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Author: 


Haig,  Robert  Murray 


Title: 


The  federal  income  tax 


Place: 


New  York 

Date: 

1921 


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Haig,  Robert  Murray,  1887-       ed. 

jjf^'  The  federal  income  tax,  by  Eobert  Murray  Haig, 
"^  Thomas  S.  Adams,  Thomas  Eeed  Powell ...  [and  othersj  a 
series  of  lectures  delivered  at  Columbia  university  in 
December,  1920,  ed.  by  Kobert  Murray  Haig  ...  with  an 
introduction  by  Edwin  K.  A.  Seligman  ...  New  York, 
Columbia  university  press,  1921. 

xii,  271  p.    23i"-. 

Half-title :  Columbia  university  lectures. 

(Continued  on  next  card) 

21-2114 
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» 


Haig,  Robert  Murray,  1887-       ed.  The  federal  in- 

come tax  ...    1921.    (Card  2)  ' 

Contents.— The  problem  in  general,  by  E.  R.  A.  Seligman.— The  con- 
cept of  income ;  economic  and  legal  aspects,  by  R.  M.  Haig. — When  is  in- 
come realized?  by  T.  S.  Adams. — Constitutional  aspects  of  federal  income 
taxation,  by  T.  R.  Powell.— The  legal  force  and  effect  of  Treasury  inter- 
pretation, by  F.  T.  Field. — Reorganizations  and  the  closed  transaction,  by 
R.  H.  Montgomery. — Loss  as  a  factor  in  the  determination  of  income,  by 
G.  E.  Holmes — Inventories,  by  A.  A.  Ballantine. — Consolidated  returns,  by 
W.  A.  Staub. — The  taxation  of  income  from  natural  resources,  by  R.  V. 
Norris. — Relief  provisions  and  Treasury  procedure  on  appeals,  by  P.  S. 
Talbert 


1.  Income  tax — U.  S. 
ell,  Thomas  Reed,  1880- 

Library  of  Congress 

Copy  2. 

Copyright    A  605607 


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THE  LIBRARIES 


SCHOOL  OF  BUSINESS 


Gift  of 

President 

Nicholas  Murray  Butler 


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Columbia  Sntbeistitp  TLtttuxti 


THE  FEDERAL  INCOME  TAX 


I 


COLUMBIA  UNIVERSITY  PRESS 
SALES  AGENTS 

New  York 

LEMCKE  &  BUECHNER 

30-32  East  2oth  Street 

London 

HUMPHREY  MILFORD 

Amen  Corner,  E.G. 

Shanghai 

EDWARD   EVANS   &   SONS,   Ltd. 

30  North  Szechuen  Road 


THE  FEDERAL  INCOME  TAX 

BY 

Robert  Murray  Haig,  Thomas  S.  Adams,  Thomas  Reed 

Powell,  Fred  T.  Field,  Robert  H.  Montgomery, 

George  E.  Holmes,  Arthur  A.  Ballantine, 

Walter  A.  Staub,  R.  V.  Norris, 

AND  p.  S.  Talbert 

A  Series  of  Lectures 

Delivered  at  Columbia  University 

in  December y  iq2o 

edited  by 

ROBERT  MURRAY  HAIG,  Ph.D. 

Associate  Professor,  School  of  Business, 
Columbia  University 

WITH  AN  INTRODUCTION  BY 

EDWIN  R.  A.  SELIGMAN,  Ph.D.,  LL.D. 

McVickar  Professor  of  Political  Economy 
Columbia  University 


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CONTENTS 

Introduction — The  Problem  in  General vii 

Edwin  R.  A.  Seligman,  McVickar  Professor  of  Politi- 
cal Economy,  Columbia  University;  Author  of  "The 
Income  Tax,"  etc. 

The  Concept  of  Income^Economic  and  Legal  Aspects  .    .         i 
Robert  Murray  Haig,  Associate  Professor,  School 
of  Business,  Columbia  University;  formerly  of  Bureau 
of  Internal  Revenue;    Author  of  "The  Taxation   of 
Excess  Profits  in  Great  Britain,"  etc. 

When  Is  Income  Realized? 29 

Thomas  S.  Adams,  Professor  of  Economics,  Yale  Uni- 
versity; formerly  Chairman,  Advisory  Tax  Board; 
now  Tax  Adviser,  United  States  Treasury. 

Constitutional  Aspects  of  Federal  Income  Taxation  ...       51 
Thomas  Reed  Powell,  Professor  of  Constitutional 
Law,  Columbia  University. 

The  Legal  Force  and  Effect  of  Treasury  Interpretation  .    .       91 
Fred  T.  Field,  of  Goodwin,  Procter,  Field  and  Hoar, 
Boston ;  formerly  member  of  the  Advisory  Tax  Board. 

Reorganizations  and  the  Closed  Transaction 114 

Lt.  Col.  Robert  H.  Montgomery,  Professor  of  Ac- 
counting, School  of  B\isiness,  Columbia  University;  of 
Lybrand,  Ross  Brothers^and  Montgomery;  Author  of 
"Income  Tax  Procedure,"  "Excess  Profits  Tax  Proce- 
dure," etc. 

Loss  as  a  Factor  in  the  Determination  of  Income  ....     137 
George  E.  Holmes,  of  the  New  York  Bar;   Author 
of  "Federal  Taxes." 

Inventories 160 

Arthur  A.  Ballantine,  of  Root,  Clark,  Buckner  and 
Howland ;  formerly  Solicitor  of  Internal  Revenue. 


VI 


CONTENTS 


( 


r 


Page 

Consolidated  Returns      i88 

Walter  A.  Staub,  Member  of  the  firm  of  Lybrand, 
Ross  Brothers  and  Montgomery,  Public  Accountants; 
Author  of  "Income  Tax  Guide." 

The  Taxation  of  Income  from  Natural  Resources  ....  222 
R.  V.  NoRRis,  Consulting  Engineer,  Wilkes-Barre, 
Pa.;  Member  and  Chairman  of  Coal  Sub-committee 
of  American  Institute  of  Mining  and  Metallurgical 
Engineers;  formerly  Engineer  to  the  United  States 
Fuel  Administration. 

Relief  Provisions  and  Treasury  Procedure  on  Appeals  .    .     250 
P.  S.  Talbert,  Consultant,  Washington,  D.  C,  for- 
merly Chairman  of  Committee  on  Appeals  and  Review, 
Bureau  of  Internal  Revenue;    formerly  Head  of  the 
Technical  Division  of  the  Income  Tax  Unit. 


INTRODUCTION 


THE  PROBLEM  IN  GENERAL 

BY 

Edwin  R.  A.  Seligman,  Ph.D,  LL.D. 

The  taxation  of  income  is  a  relatively  new  phenomenon  in 
American  fiscal  life.  Only  within  a  decade  has  the  Federal 
Constitution  been  amended  so  as  to  make  a  national  income 
tax  possible ;  and  this  amendment  came  in  the  nick  of  time.  It 
is  appalling  to  think  of  the  situation  into  which  we  should  have 
been  plunged  had  we  not  been  in  a  position  to  aliment  our 
revenues  during  the  Great  War  from  this  source.  The  very 
newness,  combined  with  the  hugeness,  of  this  fresh  device  has, 
however,  naturally  engendered  all  sorts  of  difficulties  from 
which  we  are  slowly  trying  to  extricate  ourselves. 

In  every  new  fiscal  project  there  are  three  stages  which  must 
be  traversed.  The  first  is  for  the  legislator  to  decide  as  to  the 
fundamental  principles  on  which  the  bill  is  to  be  constructed. 
These  principles  are  primarily  economic  in  character.  Inas- 
much as  fiscal  science  is  still  a  youthful  discipline  in  America 
and  in  view  of  the  comparative  insignificance  of  the  income 
tax  in  the  public  finance  of  foreign  countries,  the  economists 
have  not  yet  addressed  themselves,  with  complete  success  in 
achieving  unanimity  of  results,  to  many  of  the  problems  which 
must  guide  the  legislator.  Some  of  these  questions  have  indeed 
received  a  fairly  careful  study,  such  as  that  of  exemptions  and 
abatements  for  the  minimum  income,  the  justification  of  pro- 
gressive taxation,  and  the  position  that  ought  to  be  occupied 
by  an  income  tax  in  the  general  fiscal  scheme.  But  other  and 
equally  fundamental  problems  still  await  a  searching  examina- 
tion at  the  hands  of  economists  and  students  of  public  finance. 

At  the  very  outset  we  are  confronted  by  the  question  of 


Vlll 


INTRODUCTION 


INTRODUCTION 


IX 


fl 


¥ 


what  income  really  means.  To  this  many  answers  have  been 
given.  But  no  thoroughgoing  fiscal  analysis  of  the  conception 
has  yet  been  made,  and  as  a  consequence  no  two  countries  agree 
in  the  law  on  the  subject.  Among  the  fundamental  points  at 
issue  here  are  questions  like  the  following: 

Is  income  to  be  conceived  of  in  terms  of  money,  of  money's 
worth,  or  of  mere  psychic  benefit?  If  income  is  a  flow  and 
capital  a  fund  of  wealth,  between  what  periods  of  time  is  the 
flow  realized,  and  when  does  the  flow  congeal  into  a  fund?  Are 
both  realization  and  separation  necessary  to  the  concept  of  in- 
come? Does  income  include  the  appreciation  of  capital?  Are 
gifts  to  be  considered  income?  The  decision  as  to  these  and 
many  other  similar  questions  waits  upon  a  far  more  thorough 
analysis  than  is  found  in  the  ordinary  books. 

After  this  basic  question  is  settled  other  difficult  problems 
present  themselves.  The  general  rate  of  taxation  is  indeed 
primarily  a  political  question  and,  as  such,  one  for  the  states- 
men to  ponder  and  decide.  But  the  question  of  the  effects  of 
a  drastic  progression  and  of  the  influence  of  high  surtaxes  in- 
volves an  economic  analysis.  Again,  while  there  is  substantial 
unanimity  among  students  of  public  finance  as  to  the  desira- 
bility of  differentiating  incomes  according  to  the  sources  from 
which  they  are  derived,  there  is  great  diversity  of  opinion  as  to 
the  more  recent  proposition  of  differentiating  incomes  accord- 
ing to  the  purpose  to  which  they  are  to  be  devoted.  In  other 
words,  while  the  distinction  between  earned  and  unearned  in- 
come is  generally  accepted,  this  is  far  from  being  the  case  as 
to  the  distinction  between  income-saved  and  income  spent. 

A  similar  lack  of  unanimity  is  manifest  in  the"treatment  of 
losses,  as  contrasted  with  gains,  in  the  problem  of  wasting 
assets,  and  in  the  domain,  so  important  in  modern  industrial 
society,  of  business  reorganizations.  On  every  side,  in  fact, 
we  are  confronted  with  problems  bristling  with  difficulties,  into 
which  the  economist  has  thus  far  put  scarcely  more  than  an 
entering  wedge  and  without  a  successful  treatment  of  which 
the  legislator  must  necessarily  flounder.  It  is  the  purpose  of 
these  addresses  to  attempt  a  beginning  at  least  in  the  contri- 
bution to  a  more  thoroughgoing  economic  analysis.    Until  fis- 


cal science  reaches  a  definite  conclusion  on  these  problems  the 
way  of  the  legislator  will  be  a  thorny  one. 

In  the  second  place,  it  is  to  be  noted  that  even  though  the 
fundamental  economic  and  fiscal  principles  have  been  settled, 
the  legal  and  constitutional  aspects  of  an  income  tax  law,  as 
indeed  of  all  laws,  is  of  commanding  importance.  So  far  as  the 
mere  framing  of  the  language  is  concerned,  the  matter  can  well 
be  left  to  the  bureaus  of  legislative  drafting  and  to  the  compe- 
tent official  advisers  of  the  legislature.  However,  when  we 
leave  the  field  of  phraseology,  important  though  that  be,  and 
enter  upon  that  of  legal  and  constitutional  validity,  we  again 
encounter  many  difficulties.  Here  we  have  to  deal  not  only 
with  the  precise  legal  effect  of  the  various  provisions  of  the  act 
but  with  their  constitutional  aspects.  It  is  questionable 
whether  the  legitimate  desire  to  give  a  fixed  constitutional 
interpretation  of  a  complicated  statute  like  the  income  tax  law 
is  not  resulting  in  a  regrettable  tying  of  the  hands  of  the  legis- 
lator and  an  undue  curtailment  of  legislative  discretion,  with 
the  result  of  raising  many  new  problems  in  the  place  of  the 
single  problem  which  the  courts  endeavor  to  settle.  We  are 
already  now  beginning  to  suffer  from  a  complexity  which  is 
more  or  less  foreign  to  the  system  in  England  or  other  countries. 
Inasmuch  as  certainty  is  one  of  the  prime  requisites  of  a  good 
tax  system,  the  attempt  of  our  courts  to  achieve  certainty  and 
to  make  it  harmonize  with  constitutionality  is  one  of  supreme 
interest.  Several  of  the  addresses  in  this  course,  accordingly, 
are  devoted  to  problems  of  constitutionality  and  of  legal  inter- 
pretation. 

The  adoption  by  the  legislator  of  definite  economic  princi- 
ples and  the  enactment  of  these  principles  into  a  well-phrased, 
well-considered,  and  constitutionally  valid  enactment  consti- 
tute only  a  part  and  perhaps  even  the  minor  part  of  the  matter. 
Since  a  law  has  to  be  executed,  the  administrative  aspect  of  an 
income  tax  is  perhaps  the  most  significant  of  all.  It  is  precisely 
here  that  the  chief  difficulties  are  encountered.  For  it  is  pro- 
verbial that  democracies  are  for  obvious  reasons  relatively 
weak  in  the  administration  of  laws.  This  is  especially  true  in 
the  case  of  the  income  tax.    The  novelty  and  the  immensity  of 


ul 


'  i 


fl 


X  INTRODUCTION 

the  system  have  put  upon  our  administration  a  responsibility 
under  which  it  is  staggering  and  groaning.  The  difficulty  in  the 
problems  of  administrative  interpretation  of  the  income  tax  is 
evidenced  by  the  flood  of  administrative  regulations  which 
have  been  issued  during  recent  years. 

There  are  two  points  apart  from  the  results  of  general  po- 
litical considerations  which  distinguish  the  American  from  the 
British  income  tax  administration.  In  the  first  place,  a  broader 
discrimination  is  vested  by  the  British  law  in  the  administra- 
tive authorities  than  is  the  case  in  the  United  States.  This  lack 
of  administrative  discretion  and  the  virtual  tying  of  the  hands 
of  the  administrator  are  responsible  for  not  a  little  of  our  exist- 
ing embarrassment.  On  the  other  hand,  however,  the  attitude 
of  the  official  toward  the  taxpayer  is  different  in  the  two  coun- 
tries, perhaps  in  part  as  a  result  of  the  above  situation.  Where- 
as the  British  administrator  seeks  primarily  to  do  even-handed 
justice,  as  between  the  individual  and  the  government,  the 
American  administrator  has  as  his  paramount  aim  the  interests 
of  the  Treasury.  In  the  one  case  we  have  a  more  or  less  suc- 
cessful accommodation  with  the  particular  taxpayer;  in  the 
other  case  we  have,  frequently,  a  more  rigid  and  inelastic  inter- 
pretation of  the  law.  The  problems  of  dealing  with  the  indi- 
vidual taxpayer,  of  the  relief  provisions,  of  the  Treasury  pro- 
cedure in  particular  cases,  of  the  treatment  of  inventories,  of 
consolidated  returns  and  the  like — ^all  these  involve  adminis- 
trative problems  of  the  greatest  difficulty  and  complexity. 
Not  a  few  of  the  addresses  of  this  course  deal  with  such  problems. 

The  gentlemen  who  were  invited  to  prepare  the  follow- 
ing contributions  are  each  of  them  acknowledged  authorities 
in  their  respective  fields.  Economists,  accountants,  lawyers, 
and  administrators — they  form  a  group  the  cooperation  of 
which  is  indispensable  in  any  attempt  to  make  the  American 
income  tax  worthy  of  the  paramount  role  which  it  is  destined 
to  play  in  our  fiscal  system  for  many  a  long  year.  These  ad- 
dresses constitute,  as  a  whole,  the  most  signal  attempt  that 
has  yet  been  made  in  any  country  to  elucidate  the  basic  prin- 
ciples of  importance  to  the  framer,  the  administrator,  and  the 
payer  of  the  modern  income  tax. 


EDITOR'S  NOTE 

The  papers  printed  in  this  volume  were  read  at  Columbia 
University  in  December,  1920,  as  a  special  course  on  income 
tax  problems  offered  under  the  auspices  of  the  School  of  Busi- 
ness. The  keen  interest  shown  in  the  lectures  at  the  time  of 
their  presentation  indicated  the  desirability  of  publishing 
them  in  a  form  which  would  render  them  available  for  general 
circulation. 

In  preparing  the  manuscripts  for  the  press,  the  editor  has  in 
the  main  restricted  his  changes  to  those  which  were  necessary 
to  bring  practice  into  uniformity  with  respect  to  typography, 
form  of  references,  etc.  Because  of  the  brief  time  which  was 
available  for  editing,  a  full  checking  of  references  to  authorities 
was  not  possible  and  responsibility  for  their  accuracy  rests 
with  the  individual  authors.  It  is  also  perhaps  unnecessary  to 
add  that  neither  the  University  nor  the  editor  assumes  respon- 
sibility for  expressions  of  opinion  app)earing  in  the  papers.  No 
attempt,  of  course,  has  been  made  to  eliminate  conflicts  of 
opinion,  of  which  there  are  several  instances.  Care  is  taken  to 
call  attention  to  such  conflicts. 

The  form  of  the  references  calls  for  an  explanatory  state- 
ment. The  Revenue  Act  of  191 8  is  ordinarily  referred  to  as 
the  "1918  law**  and  its  predecessors  as  the  "1909  law,"  "1913 
law,"  "1916  law"  and  "191 7  law."  A  reference  to  a  section 
without  other  specific  citation  is  a  reference  to  the  1918  law. 
Treasury  Decision  is  contracted  to  T.  D.  Citations  in  the 
text  to  articles  without  other  designation  may  be  assumed 
to  have  reference  to  the  articles  of  Regulations  45,  the  general 
Treasury  interpretation  of  the  1918  law.  In  addition  to  the 
decisions  and  regulations,  the  Treasury  now  publishes  its 
more  formal  rulings  in  a  Bulletin  whose  issues  are  numbered 
consecutively  by  years,  No.  47-20,  indicating  that  the  num- 
ber IS  the  47th  issued  and  that  it  appeared  in  1920.  The  con- 
tents of  the  bulletins  are  consolidated  in  the  Digest  of  Income 


i\ 


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.    I 


.   I 


xii  editor'snote 

Tax  Rulings,  which  appears  from  time  to  time.    The  following 
abbreviations  are  used  in  the  Digest  and  the  Bulletin: 

Op.  A.  G.— Opinion  of  Attorney  General. 

O.  or  L.  O.— Solicitor's  law  opinion. 

Sol.  Op. — Solicitor's  opinion. 

S. — Solicitor's  memorandum.  , 

T.  B.  R.— Advisory  Tax  Board  recommendation. 

j'  B   ^ — Advisory  Tax  Board  memorandum.  ^ 

A  R.  R.— Committee  on  Appeals  and  Review  recommendation. 

^  R  M.— Committee  on  Appeals  and  Review  memorandum. 

O.  D.— Office  decision. 

The  Income  Tax  Service  of  the  Corporation  Trust  Company 
is  referred  to  as  I.  T.  S. 

In  conclusion  the  editor,  both  personally  and  on  behalf  of 
the  University,  desires  to  thank  those  who,  as  authors  of 
papers  and  as  subscribers  to  the  course,  contributed  to  the 
successful  culmination  of  the  plan  for  the  special  course  and 

the  publication  of  this  book. 

Robert  Murray  Haig 

School  of  Business 

Columbia  University  in  the 

City  of  New  York 

January  3,  192 1 


'A 


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If 

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THE  CONCEFl^  OF  INCOME— ECONOMIC  AND 

LEGAL  ASPECTS 

BY 

Robert  Murray  Haig,  Ph.D. 

The  Sixteenth  Amendment  to  the  Constitution  gives 
Congress  power  to  tax  "incomes,  from  whatever  source  de- 
rived." Acting  under  this  grant  of  authority.  Congress  has, 
for  eight  years  past,  collected  taxes  upon  what  it  has  been 
pleased  to  term  income.  In  no  one  of  the  three  statutes  passed 
during  that  time  has  Congress  attempted  to  formulate  definitely 
a  positive  definition  of  income.  Moreover,  eight  years  have 
proved  insufficient  to  secure  from  the  courts  a  fully  adjudicated 
definition.  It  is  true  that  certain  important  items,  notably 
stock  dividends,  which  Congress  has  sought  to  include  within 
the  scope  of  the  term,  have  been  eliminated  by  court  decisions. 
Much  more  important  items,  however,  await  judicial  con- 
sideration. Even  such  questions  as  the  taxability  of  gains 
from  appreciations  of  property  values  are  still  unsettled. 
Such  decisions  as  have  been  handed  down  appear  to  be  leading 
toward  a  definition  of  income  so  narrow  and  artificial  as  to 
bring  about  results  which  from  the  economic  point  of  view 
are  certainly  eccentric  and  in  certain  cases  little  less  than 
absurd.  The  unsettled  status  of  the  definition  and  the  wide"" 
differences  of  opinion  which  exist  as  to  what  the  term  income, 
as  used  in  the  Sixteenth  Amendment,  did,  does,  or  ought  to 
mean  justifies  an  examination  of  its  content  from  the  point 
of  view  of  the  economics  of  the  problem  and  from  the  point 
of  view  of  the  practice  elsewhere. 

In  this  paper  no  attempt  is  made  to  evaluate  or  criticise 
the  interpretation  of  the  statutes  or  the  Sixteenth  Amendment 
by  the  courts  from  the  point  of  view  of  general  legal  and 
constitutional    principles    involved.      This   will    be   done    in 


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2     COLUMBIA  INCOME  TAX  LECTURES 

Other  papers  to  follow.   The  approach  here  taken  is  the  broader 
one  of  fundamental  economics  and  equity. 

First  of  all,  consider  what  the  economist  means  when  he 

li^  speaks  of  income.  In  this  case,  as  in  so  many  others,  the 
economist  uses  a  term  in  approximately  the  same  sense  as 
it  is  used  in  ordinary  intercourse.  It  has  merely  been  necessary 
for  him  to  be  more  precise  as  to  exact  limits  and  distinctions. 
There  has  been  no  revolutionary  contribution  to  economic 
thought  on  this  topic  since  the  passage  of  the  Sixteenth  Amend- 
ment. The  economist  and  the  man  in  the  street  both  use 
/  the  term  now  as  they  used  it  in  1913. 

Modern  economic  analysis  recognizes  that  fundamentally 

//  incorne  is  a  flow  of  satisfactions,  of  intangible  psychological 
experiences.  If  one  receives  a  dollar  he  receives  something 
which  he  ordinarily  can  and  does  spend — perhaps  for  a  dinner. 
Is  his  income  the  dollar,  or  is  it  the  dinner  which  he  buys 
with  the  dollar,  or  is  it,  at  bottom,  the  satisfaction  of  his 
wants  which  he  derives  from  eating  the  dinner — the  comfort 
and  the  sustenance  it  yields  to  him?  If  one  spends  his  dollar 
for  something  more  durable  than  a  dinner — say  a  book  or  a 
pipe — is  his  true  income  the  book  or  the  pipe,  or  the  series 
of  satisfactions  or  "usances"  arising  from  reading  the  book 
or  smoking  the  pipe?  There  is  no  doubt  as  to  the  answer  to 
these  questions.  'A  man  strives  for  the  satisfaction  of  his 
wants  and  desires  and  not  for  objects  for  their  own  sake< 
/  How  universal  is  the  acceptance  of  this  general  view  may 
be  gauged  from  the  following  pronouncements  of  the  writers 
of  some  of  the  most  recent  and  widely  used  texts  dealing  with 
the  principles  of  economics.  Thus  Professor  Taussig,  of 
Harvard,  disposes  of  the  question: 

:^~~        Now  just  as  all  production  in  the  last  analysis  consists  in  the  creation 
of  utilities,  so  all  income  consists  in  the  utilities  or  satisfactions  created. 
Economic  goods  are  not  ends  in  themselves  but  means  to  the  end  of' 
satisfying  wants.     .     .     Our  food,  clothing,  furniture,  may  be  said  to 
yield  psychic  income.  They  shed  utilities,  so  to  speak,  as  long  as  they  last. 

Professor  Irving  Fisher,  of  Yale,  in  his  book  asserts  most 
categorically  that  "Income  consists  of  benefits,"  and,  again, 

»  Principles  of  Economics,  1916,  vol.  X,  p.  134. 


THE     CONCEPT     OF     INCOME  3 

that  "A  flow  of  benefits  during  a  period  of  time  is  called  in- 
come." * 

Professor  Ely,  of  Wisconsin,  emphasizes  the  same  point 
in  these  words: 

^  Wealth  refers  to  the  stock  of  goods  on  hand  at  a  particular  time. 
Real  mcome,  on  the  other  hand,  has  reference  to  the  satisfaction  we 
derive  from  the  use  of  material  things  or  personal  services  during  a 
period  of  time.'  ^ 

Finally,  Professor  Seligman,  in  his  Principles  of  Economics,* 
declares  that  "We  desire  things  at  bottom  because  of  their 
utility.  They  can  impart  this  utility  only  in  the  shape  of 
a  succession  of  pleasurable  sensations.  These  sensations 
are  our  true  income." 

The  testimony  of  our  leading  economists  on  this  point  is 
unanimous.  Even  in  England,  where  the  concept  of  taxable 
income  is  different  from  our  own  in  important  respects,  the 
modern  economists  recognize  the  validity  of  the  analysis  set 
forth  above.  Thus  Professor  Alfred  Marshall,  of  Cambridge 
states  that:  ' 

....     a  woman  who  makes  her  own  clothes,  or  a  man  who  digs 

wnnu  ^.rF"""^^"  ?"■  ""^P^^"?  ^'^  ^^"  *'^"^^'  is  earning  income  just  as 
would  the  dressmaker  gardener,  or  carpenter  who  might  be  hired  to 
do  the  work.  .     For  scientific  purposes,  it  would  be  best  if  the 

i^com '"''"'"^  ^         occuring  alone  should  always  mean  total  real 

However,  the  economist,  while  recognizing  all  this,  realizes 
that  before  he  can  proceed  far  with  his  analysis  of  economic 
^phenomena  he  must  arrive  at  something  more  definite  and  more 
\homogeneous— less  diaphanous  and  elusive  than  these  psychic 
satisfactions.  An  individual,  it  is  true,  can  compare  the  rela- 
tive worth  to  him  of  a  pipe  or  a  book  or  a  dinner  and  arrange 
his  order  of  consumption  without  the  use  of  any  formal  com- 
mon denominator  such  as  money.  Yet  this  individual  would 
have  great  difficulty  in  telling  you  exactly  how  much  satisfac- 
tion he  derived  from  his  pipe  or  his  book.  How  much  more 
difficult  would  it  be  for  a  second  person  to  measure  those 

» mementary  Principles  of  Ecxmomics,  191 1,  p.  34. 

»  Outlines  of  Economics,  1908,  p.  98. 

«  1914.  p.  16. 

•  Economics  of  Industry,  1901,  p.  51. 


laT         t 


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4  COLUMBIA     INCOME     TAX     LECTURES 

satisfactions  for  him  without  the  aid  of  some  common  unit! 
How  impossible  it  is  to  compare  one  man's  satisfaction  with  a 
book  with  another  man's  satisfaction  with  his  dinner !  Thus  Pro- 
fessor Taussig  is  led  to  conclude  that: 

for  almost  all  purposes  of  economic  study,  it  is  best  to  con- 
tent ourselves  with  a  statement,  and. an  attempt  ''t  mea^~nt 
in  terms  not  of  utility  but  of  money  income.     .     •  .  1  he  reason  lor 
thisTeTectton  of  a  principle  which  is  in  itself  sound  lies  in  the  conclus'°" 
.  regarding  total  utility  and  consumer's  surplus:  They  cannot 

be  measured.' 

The  basis  of  companson,  the  foundation  upon  which  eco- 
nomic interaction  and  exchange  take  place  is,  of  course,  that 
of  the  common,  universally-acceptable  unit  of  value-money. 
The  usances  and  satisfactions  and   the  goods  and  services 
supplying  them  which  are  of  significance  to  the  economist  m 
his  analysis  are  those  which  are  susceptible  of  evaluation  in 
terms  of  money.     This,  of  course,  involves  the  element  of 
scarcity,  relative  to  demand.    When  one  can  express  his  wants 
and  satisfaction  in  terms  of  dollars  and  cents  he  can  use  a 
language  which  other  men  can  understand  and  which  means 
something  to  the  economic  community  generally. 

It  should  be  carefully  noted,  however,  that,  first,  when  one 
Abandons   "usances"   and   satisfactions   and   substitutes   the 
goods  and  services  yielding  these  satisfactions,  he  is  taking  a 
step  away  from  the  fundamentals,  for  two  equal  sets  of  goods 
and   services   may   yield   very   different   satisfactions;    and 
second,  if  one  takes  the  next  step,  as  most  income  tax  laws 
do  in  the  main,  and  substitutes  money  received  dunng  a 
period  in  place  of  goods  and  services  used,  as  the  content  of 
the  term  income,  he  has  really  moved  a  very  appreciable  dis- 
tance from  the  fundamental  conception,  for  not  only  does 
everyone  receive  goods  and  services  of  greater  or  less  amount 
without  buying  them  with  money,  but  also  everyone  is,  in 
effect,  considered  to  be  in  receipt  of  his  income  when  he  gets 
the  money  with  which  to  buy  the  goods  and  services  which 
will  yield  the  usances  and  satisfactions  which  go  to  make  up 
his  true  income.    Indeed,  the  purchase  of  the  goods  and  ser- 

•  Taussig,  loc.  cit. 


f 


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THE     CONCEPT     OF     INCOME  5 

vices  may,  of  course,  be  postponed  indefinitely.    In  the  words 
of  Professor  Ely: 

Money  income  should,  perhaps,  refer  to  the  value  of  the  goods  con- 
sumed and  the  services  enjoyed,  although  in  popular  speech  and  by 
many  economists  the  word  is  used  in  the  literal  sense  of  the  net  amount 
of  money  that  comes  in,  whether  it  is  spent  for  enjoyable  things  or  is 
saved.' 

It  is  apparent  from  what  has  been  said  that  when  taxable 
income  is  identified  with  money  received  in  a  given  period  two 
approximations  have  been  introduced,  each  of  which  involves 
anomalies  and  inequalities  as  beH^een  members^  the  same 
class  ostensibly  on  equal  terms.  For  example,  two  persons 
who  receive  precisely  equal  amounts  of  goods  and  services 
may  derive  therefrom  very  unequal  "usances"  and  satisfactions. 
If  "usances"  and  satisfactions  are  really  the  proper  theoretical 
basis  for  apportioning  the  tax  burden^  there  is  here  an  in- 
equality. Certainly,  everyone  will  agree  that  they  constitute 
an  entirely  impracticable  basis.  Consequently,  any  theoretical 
injustice  involved  must  necessarily  be  incurred  if  we  are  to  have 
an  income  tax  at  all.  But  is  there,  after  all,  any  theoretical 
injustice?  Who,  for  instance,  would  seriously  defend  the 
proposition  that  taxes  should  be  apportioned  according  to 
capacity  for  appreciation  rather  than  according  to  the  capacity 
to  command  the  goods  and  services  which  are  appreciated? 
The  only  economically  significant  goods  are  those  which  are 
susceptible  of  evaluation  in  terms  of  money. 

In  the  next  place,  two  persons  who  receive  precisely  equal 
amounts  of  money-income  may  receive  very  unequal  amounts 
of  goods  and  services,  either  because  one  has  postponed 
spending  a  larger  pSrtion  of  his  money  than  the  other,  or 
because  one  has  received  more  income  in  kind.  No  great 
harm  is  done  if  the  person  whn  postpones  spending  his  mon«y 
!^  taxed  upon  it  when  hp  rprpjvpg  it  rather  than  when  he  spends 
It.  However,  it  is  a  different  matter  in  the  case  of  income^ 
kind,  such  as  the  fire-wood  the  farmer  cuts  from  his  wood  lot 
or  the  vegetables  for  his  table  which  he  gathers  from  his 
garden.  Certainly,  the  fact  that  one  man  buys  his  fire-wood  or 

^  Ely,  loc.  cit. 


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6     COLUMBIA  INCOME  TAX  LECTURES 

his  vegetables,  rather  than  receives  them  without  the  formality 

of  a  money  sale,  should  not  operate  so  as  to  increase  the  weight 

of  his  income  tax.     The  economics  of  this  situation  is  very 

clear.    /The  statement  made  in  the  preceding  paragraph  is 

'^  that  the  goods  and  services  which  are  of  significance  are  those 

which  are  susceptible  of  evaluation  in  terms  of  money.     It  is 

not  necessary  that  they  should  actually  have  passed  through 

the  process  of  a  sale.     From  the  point  of  view  of  equity  it  is 

{theoretically  important  that  all  goods  »  and  services  received 

y   ^/  Iwithout  payment  should  be  accounted  for  in  case  it  is  possible 

*  ko  value  them  in  terms  of  money. 

Perhaps  it  is  clear,  then,  how  and  why  the  fundamental 
economic  conception  of  income  as  a  flow  of  satisfactions  must 
undergo  substantial  modification  to  'fit  it  for  use  in  economic 
analysis  generally  and  for  use  particularly  as  a  basis  for 
apportioning  a  tax  burden.  The  satisfactions  themselves 
become  economically  significant  for  the  purpose  only  when 
they  are  susceptible  of  evaluation  in  terms  of  money.  .  It  is 
necessary  as  a  practical  proposition  to  disregard  the  intangible 
psychological  factors  and  have  regard  either  for  the  money- 
worth  of  the  goods  and  services  utilized  during  a  given  period 
or  for  the  money  itself  received  during  the  period  supplemented 
by  the  money-worth  of  such  goods  and  services  as  are  received 
directly  without  a  money  transaction. 

If  the  first  option  is  taken,  viz.,  the  money-worth  of  the  goods 
and  services  utilized  during  a  given  period,  we  arrive  at  a 
pure  consumption  tax,  unless  indeed  we  attempt  an  evaluation 
of  the  satisfactions  arising  from  the  consciousness  of  a  saved 
surplus  which  is  obviously  an  impracticable  procedure.  It  is 
interesting  to  recall  that  this  is  the  resifit  which  the  English 
economist,  John  Stuart  Mill,  sought^  to  establish  a  half- 
century  ago,  although  the  analysis  underlying  his  conclusions 
was  a  quite  different  one.  '  To  tax  saved  income  and  then  in 
future  years  to  tax  the  income  from  those  savings  was,  he 
contended,    double    taxation.*      The    same    conclusion    has 

*  For  gifts,  cf.  infra.,  p.  26. 

•  The  source  of  this  and  several  other  statements  made  in  this  paper  with  respect  to  the 
theories  of  foreign  economists  is  an  unpublished  monograph  by  Mr.  Clarence  Heer,  a 
former  student  in  the.seminar  of  Professor  Seligman. 


THE     CONCEPT     OF     INCOME 


f  f 


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been  reached  by  certain  Italian  writers,  notably  Einaudi  '• 
^The  second  option,  however,  has  been  the  one  generally  j, 
adopted  as  the  definition  of  income  in  modern  income  tax 
acts.  IJJnder  this  conception,  income  becomes  the  increase  or 
accretion  m  one's  power  to  satisfy  his  wants  in  a  given  period. 
•  m  so  far  as  that  power  consists  of  (a)  money  itself,  or,  (b) 
anything  susceptible  of  valuation  in  terms  of  money  More 
simply  stated,  the  definition  of  income  which  the  economist 
offers  IS  this:  Income  is  the  money  value  of  the  net  accretion  to  I  w 
one  s  economic  power  between  two  points  of  lime7\  '  -^ 

It  will  be  observed  that  this  definition  depirts  in  only  one 
important  respect  from  the  fundamental  economic  concep- 
tion of  income  as^a^floj^oLsatisfactions.  Qt  defines  income  in-^J 
terms  of  power  to  satisfy^ewromc  wants  rather  than  in  ^ 
terms  of  the  satisfactions  themselves.  It  has  the  effect  of 
taxing  the  recipient  of  income  when  he  receives  the  power  to 
attain  satisfactions  rather  than  when  he  elects  to  exercise  that 
P"*'^!!:!'^'"^  ^''°"'«1  "io  n°  violence  to  our  sense  of  equity  how- 
ever.-yhe  fact  that  a  man  chooses  to  postpone  the  gratifica- 
hfe"ta^  ^^"^  ''  "°  suflficient   reason    for    postponing/ 

It  will  be  readily  agreed  that   this  definition,  viz.,   that   - 
income  is  the  net  accretion  to  one's  economic  strength   in  a  f  ^ 
given  period,  constitutes,  then,  the  closest  practicable  approxi-  i^ 
mation  of  true  income.    It  coincides  very  closely  indeed  with  1/ 
the  flow  of  economic  "usances"  and  satisfactions  expressed  in 
terms  of  money,  which  all  economists  agree  constitutes  the 
thing  after  all  we  are  attempting  to  measure.    Certainly  this 
definition  is  scientific  in  the  sense  that  it  is  broad  enough  to  »/ 
include  everything  of  like  nature.    Anomalies  are  avoided  by 
the  very  simple  expedient  of  casting  the  definition  in  broad 
terms.    On  the  other  hand,  is  the  definition  so  broad  that  it 
mcludes  Items  fundamentally  dissimilar?    The  test  of  similar- 
ity applied  IS  power  in  terms  of  money  to  command  goods  and 
services  yielding  usances  and  satisfactions.     Is  it  possible  to 
add  any  other  test  without  so  restricting  the  definition  as  to 
exclude  Items  which  should  be  included  and  thus  introduce' 

"  Luio  Einaudi,  C^-so  di  Scu,u  Mia  R«,„,  3rd  Edition,  Capitalo  4. 


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8     COLUMBIA  INCOME  TAX  LECTURES 

inequities  and  discriminations  as  between  persons  in  substan- 
tially  identical  economic  positions?  Professor  Sehgman  believes 
that  in  addition  to  the  criteria  of  monex:value,  pei_ipdicity, 
and  realization  included  in  the  definition  as  stated  above, 
there  sh^uTd'also  be  applied  the  test  of  separation  as  a  neces- 
sary attribute  of   income."    Much  depen-^s  upon   precisely  • 
what  is  meant  by  separation.     Included  in  the  test  of     sus- 
ceptibility of  evaluation"  is  certainly  the  condition  that   the 
valuation    attached    to   the   accretion    must    be   sufficient^ 
definite  to  form  the  basis  for  a  realization.    The  item  must  be  • 
^'  realizable  and  separable,  certainly.    That  there  must  be  an    ^ 
actual  physical  separation,  however,  before  economic  income 
is  realized,  cannot,  I  believe,  be  conceded,  for,  with  a  defini- 
tion so  narrowed  it  is  not  possible,  in  the  stock-dividend  case 
for  example,  to  remove  the  inequity  as  between   different 
classes  of  security  holders.    The  adoption  of  the  definition  as 
developed  above  leads  to  the  same  conclusion  as  that  reached 
by   Professor  Seligman,  viz,,    that  stock-dividends  are   ii^ 
income,  but  the  reason  is  not  that  the  i"^«"^^  j^.^^/^' ^^^ 
accrued  to  the  shareholder  when  the  stock-dividend  is  declared, 
but  rather  that,  economically,  it  has  accrued  to  the   share- 
raHiTi^n  before  the  stock-dividend  was  declared,  m.,  if 
and  when  the  improved  economic  position  of  the  corporation 
was  reflected  in  the  holdings  of  the  stockholder  with  sufficient 
definiteness  to  be  susceptible  of  evaluation. 
^     What  more  narrow  definition  than  the  one  suggested  will 
solve  the  problems  presented  by  the  following  three  questions? 

1  Are  stock-dividends  income? 

2  Is  undistributed  surplus  income  to  the  shareholder? 
-i    Are  appreciations  in  property  values  income? 

s  I  Are  stock-dividends  income?  The  Supreme  Court  has 
decided  that  stock-dividends  are  not  incom^;^  What  ,s  the 
effect  of  this  decision  upon  the  economic  position  of  the  three 
following  persons,  ^,  5,  and  C,  who  are  shareholders  in  similar 
corporations,  each  owning  ten  per  cent,  of  the  stock?    Assume 

u  Edwin  R.  A.  Seligman.  "Are  Stock  Dividends  Income?"   American  Economic  Review 

September.  iQip.  ^  tt  c   ,»« 

«  Towne  v.  Eisner.  24s  U.  S.  418;   Eisner  ..  Macomber.  252  U.  S.  189. 


11 


THE     CONCEPT     OF     INCOME  9 

that  each  company  makes  $1,000,000  in  the  given  accounting 
period.  On  the  day  of  the  directors'  meeting  when  the  ques- 
tion of  the  declaration  of  a  dividend  will  be  considered,  the 
economic  position  of  all  three  men  is  the  same,  and  no  one 
would  deny  that  the  economic  strength  of  each  had  been 
increased  by  virtue  of  his  ten  per  cent,  interest  in  a  corpora- 
tion which  has  earned  a  million  dollars  net  income.  A's  cor- 
poration declares  a  cash  dividend  of  $1,000,000,  A's  share 
being  $100,000  in  money.  B's  corporation  declares  a  stock- 
dividend  of  $1,000,000,  B's  share  being  $100,000  in  stock. 
Cs  corporation  declares  no  dividend,  Cs  interest  in  the  earn- 
ings of  that  year  being  reflected  presumably  in  an  increase  in 
the  market  value  of  his  stock.  Before  the  stock  dividend 
decision  A's  share  and  B's  share  were  both  considered  taxable 
income!  C  was  taxed  only  if  and  when  the  profits  were  dis- 
tributed— unless  in  truth  he  were  taxed  indirectly  in  case  he 
sold  his  stock  at  an  appreciated  value.  A  and  B  were  to- 
gether in  one  class.  C  was  alone  in  a  second  class.  As 
between  the  two  classes^  there  was  a  marked  difference  of 
treatment.      The  stock    dividend   decision   disassociated    B 

'  from  A  and  placed  him  in  the  class  with  C.  The  line  mark- 
ing the  difference  of  treatment  is  now  no  longer  drawn  be- 
tween B  and  C.  It  is  drawn  between  A  and  B.  But  the 
point  is  that  the  difference  persists.    Can  justice  be  established 

\  in  an  income  tax  as  among  ^,  B,  and  C  by  any  action  short  of 
making  each  of  them  subject  to  income  tax  upon  the  increase 

!  in  his  economic  strength  resulting  from  the  earnings  of  the 

[  corporation  in  which  he  is  interested?  In  this  case  A  should 
account  for  the  |>ioo,ooo  cash  dividend  in  his  income  tax 
return.    B  should  account  for  the  market  value  of  his  stock 

•  dividend  on  the  last  day  of  the  year,  minus  any  decline,  if  any, 
in  the  market  value  of  his  original  block  of  stock  during  the 
year.  C  should  be  taxed  on  the  increased  market  value  of  his 
block  of  stock.  All  of  them,  under  the  assumption,  have 
received  a  net  accretion  of  economic  strength  during  the  year 
.definite  enough  to  be  susceptible  of  evaluation.  Can  a  more 
narrow  concept  of  income  than  this  solve  the  problem  here 
presented? 


10 


COLUMBIA  INCOME  TAX  LECTURES 


THE  CONCEPT  OF  INCOME 


II 


II 


2.   75  undistributed  surplus  income  to  the  shareholder?    The 
problem  with  respect  to  the  taxation  of  undivided  surplus 
may  be  presented  best  by  a  similar  example.    Assume  that  A 
owns  ten  per  cent,  of  the  stock  of  a  corporation  and  that  B 
owns  a  ten  per  cent,  interest  in  a  partnership,  each  of  which 
earns  $1,000,000  during  a  given  accounting  period.    B  must 
include  in  his  individual  income  tax  return  his  distributive 
share  of  the  profits,  $100,000,  which  item  becomes  subject  to 
both  normal  and  surtax  rates.    On  the  other  hand,  A  includes 
in  his  personal  income  tax  return  his  share  of  the  profits  m 
his  corporation  only  if  and  when  these  profits  are  declared  as 
dividends.    If  they  are  never  distributed,  they  never  become 
subject  to  the  individual  surtax  rates.    The  corporation,  it 
is  true,  pays  the  so-called  normal  tax  at  the  time  when  the 
profits  are  earned,  and  A  may  take  credit  for  part  of  this 
normal  tax  in  his  individual  return  when  he  receives  the  divi- 
.  dend.     It  is  also  true  that  the  Excess  profits  tax  applies  to 
corporate  profits  and  not  to  partnership  or  individual  profits 
and  that  for  the  present  this  has  brought  about  a  condition 
of  poise  which  will  be  sadly  disturbed  if  the  excess  profits  tax 
should  disappear.     But  what  precise  solution  is  there  for  this 
badly  muddled  situation  short  of  the  adoption  of  a  concept 
of  income  broad  enough  to  tax  A  on  the  increased  market 
value  of  his  stock  which  presumably  results  from  ploughmg 
the  earnings  back  into  the  business  of  the  corporation?     In 
the  absence  of  dependable  market  quotations,  would  not  the 
accounts  of  the  corporation,   as   to   undistributed   surplus, 
furnish  light  as  to  the  increase  in  A's  economic  position? 
2,.   Are  appreciations  in   property  values  income?    At  the 
»^  present  time  we  consider  appreciations  of  property  values 
taxable  income."  But  we  inventory  nothing  except  stock-in- 
trade.    In  other  words,  we  say  in  effect  that  nothing  appre- 
I  dates  in  value  until  it  is  sold.    This,  of  course,  is  not  in  accord 

w  In  a  decision  published  after  this  paper  was  written.  Judge  J.  D.  Thomas,  of  the  Di^ 
trict  Court  of  the  United  States.  District  of  Connecticut,  has  decided,  in  the  case  of  Brewster 
•.  Walsh.  CoUector  (No.  2133  at  law),  that  the  increase  in  the  value  of  capital  a»et.  when 
realized  by  sale  or  other  disposition,  by  one  not  a  trader  or  dealer  therein  is  not  income, 
and  hence  is  not  taxable  as  such.  The  Government  has  announced  an  appeal  to  the  Supreme 
Court. 


with  economic  facts,  however  perfectly  it  may  synchronize 
with  accounting  practice.  [The  truth  is  that  certain  so-called 
accounting  principles  have  been  evolved  with  other  ends 
primarily  in  view  than  the  accurate  determination  of  relative 
taxpaying  abilityj  The  general  result  may  be  illustrated  as 
follows:  A  and  B  each  buy  houses  in  1914  for  $10,000.  Both 
houses  appreciate  in  value  until  they  are  worth  $20,000  each 
in  1916.  A  sells  his  house  in  191 6  and  becomes  taxable  on  the 
$10,000  profit.  The  highest  surtax  rates  in  1916  were  thirteen 
per  cent.  He  holds  his  $10,000  uninvested.  B  retains  his 
house,  but  after  1916  the  value  remains  stationary.  He  sells 
in  1920  and  realizes  $10,000  profit.  In  1920  the  rates  range 
as  high  as  seventy-three  per  cent.  Here  are  two  men  whose 
economic  strength  has  varied  in  precisely  the  same  manner. 
They  are  called  upon  to  pay  quite  different  amounts  in  federal 
income  taxes.  Can  any  proposal  offer  a  satisfactory  solutiorTl 
of  this  problem  which  does  not  assume  a  concept  of  income  \ 
similar  to  that  outlined  above?  To  achieve  exact  justice  the 
I  •  increased  economic  strength  of  the  two  men  must  be  measured  | 
period  for  period,  - 

The,general   conclusion   from  the  foregoing  discussion  is    '/ 
this:  [That  the  economist  when  asked  whether  a  particular, 
item  IS  income  or  is  not  income,  must,  in  the  opinion  of  the 
writer,  make  his  reply  depend  upon  whether  the  receipt  of  j| 
that  item  has  increased  the  economic  power  of  the  recipient 
to  command  satisfaction-yielding  goods  or  services.  ^  If  it 
does,  it  is  income;  if  it  does  not,  it  is  not  income.-  The  answer 
would  then  be  based  on  practically  the  bed-rock  of  economic 
principle — not  quite,  perhaps,  because  of  the  approximations 
already  pointed  out,  but  certainly  on  a  level  as  near  as  is 
practicable  to  that  bed-rock.     It  courts  are  to  base  their 
decisions  on  economic  principle,  the  answer  to  their  queries 
should  be  in  terms  of  the  most  fundamental  of  principles. 

These  statements  present  nothing  which  is  really  novel. 
This  same  doctrine  has  long  been  taught  by  that  faithful  hand- 
servant  of  the  practical  business  man — the  accountant. 
When  one  examines  the  standard  books  dealing  with  the 
theory  of  accounting  he  finds  the  definition  of  the  net  profit 


^  ^ 


\ 


:»^af.a^ 


il 


12         COLUMBIA     INCOME     TAX     LECTURES 

Of  a  business  undertaWng  stated  in  almost  the  precise  words 
used  in  the  general  de\nition  given  above.    Thus.  A  Lowes 
Dickinson  in  his  Accotmting  Practice  and  Procedure  »  says: 
In  the  widest  possible  vi^w.  profits  may  be  stated  as  the  re^>'^«^ 
increment Th  the  value  of  the  whole  amount  invested  m  an  undertakmg, 
and,  conversely,  loss  is  the  realized  decrement. 
.     Again,  Robert  H.  Montgomery  in  his  Audiling  remarks: 
If  an  absolutelv  accurate  balance  sheet  could  be  prepared  at  the 
beiinnrng  and  the  end  of  a  period,  the  difference  would  constitute  the 
net  profit  or  the  net  loss  for  the  term. 

The  economist  and  the  accountant  are  also,  of  course,  in 
complete  accord  as  to  the  theoretical  distinction  between 
income  on  the  one  hand  and  capital,  or  property,  or  wealth 
on  the  other.  The  accountant's  "absolutely  accurate  balance 
sheet."  to  use  Montgomery's  phrase,"  is  synonymous  with  the 
economist's  "fund  relating  to  a  given  instant,'  -  to  use  P  o- 
fessor  Fisher's  language,  or.  "accumulation  of  .  .  .  utilities 
or  income  at  an  instant  of  time."  "  to  use  Professor  Sel.gmans 
expression.  The  establishment  of  "net  income,  both  agree, 
must  not  involve  an  impairment  of  the  capital  sum^ 

Confusion  of  thought  is  sometimes  caused  by  the  fact  that 
the  accountant  usually  speaks  in  terms  of  a  business  enter-  • 
prise  as  a  separate  entity,  while  the  economist  usually  speaks 
in  terms  of  the  individual  person.    The  distinction  between 
gross  and  net  income-which  occupies  so  large  a  part  of    he 
attention  of  the  accountant-is  summarily  dismissed  by  the 
economist  whose  typical  income  receiver  is  the  man  whose 
expenditures   are   predominantly   for   purposes   of   personal 
consumption.    The  definitions  and  reasoning  of  the  a«°""^- 
ant.  however,  are  very  readily  fitted  to  the  case  of  this  typical 
economic  man  if  the  accounting  period  is  reduced  to  its  true 
economic  length,  which  in  the  case  of  the  wage  earner  ,s  a 
week  and  the  salaried  worker  a  month.    In  the  typical  business 
the  period  is,  of  course,  a  year,  the  net  income  not  being 
determined  and  distributed  until  the  end  of  that  period. 

M  p.  67. 

"  1516,  p.  206. 

i«  Fisher,  op.  ciU,  pp.  s6-57- 
>'  Seligman,  loc.  cit. 


THE     CONCEPT     OF     INCOME 


13 


W 


|j/     xhe  detailed  technique  of  determining  the  precise  deductions 
which  should  properly  be  made  as  business  expenses,  as  con-  // 
trasted  with  expenditures  of  a  capital  nature,  has  been  devel-x 
oped  by  the  accountants  along  lines  entirely  acceptable  to 
the  economist.     Many  interesting  theoretical  questions  are 
involved,  such,  for  example,  as  the  degree  to  which  risk  may 
properly  be  insured  against  by  means  of  various  reserves, 
but  a  survey  of  this  portion  of  the  field — while  germane  to 
the  topic — cannot  be  developed  in  the  time  available.     Or- 
dinarily the  economist  contents  himself  with  the  assertion 
that  the  income  must  be  net,  that  all  expenses  connected  '/ 
with  its  production  must  have  been  met. 

The  problem  of  distinguishing  sharply  between  business 
expense  and  personal  expense  is  one  which  is  the  occasion 

*  of  much  practical  difficulty  and  upon  which  wide  differences 
of  opinion  exist.  Certain  German  writers,  e.g.,  Weissenborn,** 
go  so  far  as  to  classify  all  personal  and  family  expenditures 

•  for  food,  clothing,  and  shelter  as  deductible  expenses,  rendering 
the  income  tax  substantially  a  tax  on  merely  saved  income. 
This  is  a  result  diametrically  opposite  to  that  reached  by 

'    the  English  and   Italian  economists  referred   to  above  ^^ —    | 
and  it  is  a  conception  which  does  not  find  any  considerable   I 
response  except  in  so  far  as  the  relief  of  a  bare  minimum  of  \ 
subsistence,  under  the  various  personal  exemptions,  may  be 
conceived  to  be  such  a  response.  . 

It  is  often  a  long  step,  however,  between  the  accountant's 
theory  and  his  practice;  between  his  abstract  statement 
as  to  what  net  profit  is  and  the  actual  figure  certified  as  such 
on  a  balance  sheet.  It  is  an  equally  long  step  for  the  econ- 
omist between  his  general  definition  of  income  and  the  content 
of  the  category  which  in  his  opinion  forms  the  best  basis  for 
the  imposition  of  an  income  tax.  This  is  a  practical,  work- 
aday world  full  of  imperfections.  Most  economists,  popular 
superstition  to  the  contrary,  are  fairly  conversant  with  the 

1^  facts  of  modern  business  life  and  are  fairly  well  aware  of  the 
practical  difficulties  of  fitting  abstract  conceptions  to   the 

"  Di>  Besteuerung  nach  dem  Ueberfluss,  1911. 
*•  Cf.  supra,  pp.  6-7. 


A 


f 


..X" 


flfllt! 


I  I 


-/ 


( 


14        COLUMBIA     INCOME    TAX     LECTURES 

environment  of  the  market-place.    Certainly  m°dif  ^ations- 
serTous  modification^must  be  made  in  the  general  defin  t^ 
of  income,  as  formulated  above,  to  fit  .t  for  use  as  the.tem 
of  net  income  entered  on  Form  1040  or  Form  1 120   and  the 
scientific  economist  in  advising  the  legislator  would  be  the 
at  to  suggest  an  attempt  to  follow  the  imphcat.ons  of  h,s 
analysis  wfthout  regard  to  the  limitations  .mposed  by  the 
actual  conditions  under  which  the   ^w  must  funcnon     Su^ 
a  course  would  be  anything  but  scientific     The  pomt  to  be 
IrZei  very  clearly,  however,  is  this:  /Those  mod'fications  ^ 
to  wWch  he  would  consent  and  which,  indeed,  he  is  among 
the  first  to  urge,  are,  after  all  is  said  and  done,  merely  mod.fica- 
tion^merely  concessions  made  to  the  exigencies  of  a  given 
situation.,  fbr  example,  one  might  urge  that  no  tax  be  placed  , 
Ta  gain  afeing  from  the  appreciation  of  a  fixed  a^t-ti 
it  is  actually  sold.    But  the  recommendation  should  not  be  ^ 
urged  on  the  ground  that  the  appreciation  is  not  income  unti 
k  is  sold/  The  economic  fact  is  that  the  owner  of  that  asset 
^^^Sniito  possession  of  economic  income  whenever  the  in-  . 
crease  in  the  value  of  that  asset  is  sufficient  in  amount  and 
definite  enough  in  character  to  be  susceptible  of  P-«- --'"f  " 
tion  in  terms  of  money.    Again,  one  might  urge  that  no  tax 
be  placed  on  the  services  which  one  actually  enjoys  when  he 
lives  in  his  own  home  rather  than  a  rented  one.    But.  again 
that  recommendation  should  not  be  supported  by  the  assertion 
that  this  item  is  not  income.     It  is  income  whenever  it  is 
^susceptible  of  evaluation . in  terms  of  money.     Neither  the 
economist  nor  the  courts  should  express  their  opinions  in 
the  form  of  an  assertion  that  it  is  not  income     That  it  seems 
to  the  writer,  is  not  the  real  question  in  either  of  the  illu  ^ 
trations  given.    The  real  question  is.  rather:   Is  it  justifiable 
to  treat  this  item  of  income  In  some  speaal  way  as  compared 
with  other  items  of  income  because  of  special  «rcumstances 
surrounding  its  receipt?  Thus,  it  may  be  futile  and  ^lUy.  from 
an  administrative  point  of  view,  to  attempt  to  include  m 
the  income  tax  return  a  money  estimate  of  the  income  which 
the  man  receives  when  he  lives  in  his  own  house.  The  Wisconsin 
authorities,  after  attempting  to  list  such  income  for  several 


THE     CONCEPT     OF     INCOME 


15 


A« 


V*^*** 


/ 


years(*  have  decided  that  the  game  is  not  worth  the  candle.  ^ 
Or,  it  may  be  impracticable  as  an  accounting  proposition, 
to  reflect  the  varying  worth  of  capital  assets  on  the  balance 
sheet.    As  the  accountant,  Dickinson,  points  out: 

Inasmuch  ...  as  the  ultimate  realization  of  the  original  invest- 
ment is  from  the  natuie  of  things  deferred  for  a  long  period  of  years, 
during  which  partial  realizations  are  continually  taking  place,  it 
becomes  necessary  to  fall  back  on  estimates  of  value  at  certain  definite 
periods,  and  to  consider  as  profit  and  loss  the  estimated  increase  or 
decrease  between  any  two  such  periods.'® 

If  the  difficulties  of  complete  periodical  revaluations  are  sol 
great  as  to  make  it  impracticable  to  tax  appreciations  as  they/ 
accrue,  they  ought  not  to  be  so  taxed,  and  the  question  is 
transformed  into  these  new  queries:  "When  may  these  appre- 
ciations best  be  taxed?"  and  "If  they  are  taxed  sporadically 
is  the  result  so  unjust  that  no  attempt  should  be  made  to 
tax  them  at  all?" 

To  the  writer  it  seems  unfortunate  that  the  questions  as  to 
the  constitutionality  of  the  federal  income  tax  on  specific  items 

•  are  turning  so  largely  on  the  quesUon  as  to. whether  the  items  c 
are  or  are  notlricbme.    The  items  most  controverted  certainly  i 
fall  withm'the  definition  of  income  established  by  the  analysis 

•  of  business  facts  made  by  both  the  economist  and  the  accoun- 
tant. Moreover,  the  concept  of  income  is,  after  all,  essentially  • 
an  economic  concept,  and  if  the  legal  concept  established  by 
court  interpretation  under  a  particular  constitutional  provision 
or  amendment  departs  in  any  very  fundamental  fashion  from 
the  economic  concept,  injustices  may  arise  of  such  magnitude 
as  to  necessitate  either  the  abandonment  of  the  income  tax  or 
the  adoption  of  a  constitutional  amendment  which  will  give  a 
positive  and  comprehensive  definition  of  income.  The  difficulty 
could  be  avoided  if  the  broad  economic  concept  of  income  were 
frankly  accepted  with  its  single  test  as  to  whether  the  item^ 
resulted  in  an  improvement  in  economic  power  capable  of ) 
being  evaluated.  The  questions  which  the  courts  would  then 
be  called  upon  to  consider  would  be  as  to  whether  the  modifica- 
tions made  by  Congress  and  by  the  Treasury,  in  attempting  to 


^  X 


! 


^a4\ 


I 


l6         COLUMBIA     INCOME     TAX     LECTU. 

construct  a  concept  of  taxable  income  which  will  be  at  once 
workable  and  approximately  just,  are  modifications  which  are 
reasonable  and  in  conformity  with  the  various  constitutional 
guaranties. 

It  goes  without  saying  that  taxable  income  under  an  income 
tax  law  should  approximate  as  nearly  as  practicable  the  true 
net  income  as  defined  by  the  analysis  of  the  economist  and  the 
accountant.  How  close  an  approximation  is  possible  depends 
upon  the  perfection  of  the  environment  in  which  the  tax  must 
y;  live.  No  unnecessary  departure  from  the  true  concept  should 
be  made.  The  imperfections  of  our  present  economic  environ- 
M  ment  which  are  of  most  significance  to  this  problem  fall  into 

three  classes: 

I.   The  imperfections  of  the  economic  standard  of  value; 
)   2.   The  imperfections  of  accounting  practice;    and 

3.   The  imperfections  of  the  administration. 

A  perfect  income  tax  is  unattainable  so  long  as  modifica- 
tions must  be  made  because  of  imperfections  in  our  standard 
of  value,  our  accounting,  and  our  administration.  These  classes 
will  be  taken  up  in  turn. 
y  "ki.   Imperfections  of  the  economic  standard  of  value.     That 
^   variations  occur  from!  time  to  time  in  the  price  level  and  in  the 
value  of  money  is  well  known  to  every  person  whose  resources 
during  recent  years  have  been  sufficiently  limited  to  compel 
him  to  have  any  regard  at  all  for  his  expenditures.    If  income 
is  defined  as  the  total  accretion  in  one's  economic  strength 
between  two  points  of  time,  as  valued  in  terms  of  money,  it  is 
clear  that  his  income  will  reflect  every  change  in  the  value  of. 
money  between  those  two  points  of  time  in  so  far  as  the  items 
entered  on  the  balance  sheets  at  those  times  affect  the  compu- 
tation.   If  the  level  of  prices  goes  up  ten  per  cent,  the  money 
value  of  my  assets  willK)rdinarily  follow  at  a  like  rate.     That 
particular  increase  in  value  does  not  really  indicate  an  increase 
in  my  economic  strength.    My  power  to  command  economic 
goods  and  services  halnot  increased,  for  the  money-value  of 
these  goods  and  services  has  likewise  increased.    So  long  as  we 
have  a  money  standard  which  varies,  we  shall  find  that  even  a 
perfect  accounting  system  will  show  a  net  income  which  is  not 


THE     CONCEPT     OF     INCOME 


17 


,f 


identical  with  the  true  accretion  of  economic  power.  Indeed, 
the  more  perfect  the  valuation  and  the  accounting,  the  greater 
will  this  injustice  be. 

It  must  be  borne  in  mind,  however,  that  this  is  an  evil  which 
is  with  us  under  our  present  law.    A  man  who  sold  an  asset  inj 
1920  which  he  had  purchased  in  1914,  making  an  apparent 
profit  of  100  per  cent,  and  receiving  his  pay  in  fifty-cent  dollars  ' 
is,  under  our  statute,  subject  to  tax  on  his  gain,  although  that 
gain  is  onfy  apparent  and  not  real.    Moreover,  the  situation  is 
particularly  unjust  under  our  present  system.     If  complete 
periodical  revaluations  were  used  in  determining  income  there  ' 
would  still  be  relative  equality  as  between  different  taxpayers.- 
But  as  the  situation  now  stands,  the  transactions  are  closed  in 
a  haphazard  and  uneven  fashion.    A  man  who  happens  to  sell 
out  at  the  peak  of  the  price  curves,  is  taxed  very  unequally  as 
compared  with  the  man  who  continues  his  transaction  until  a  ' 
period  of  lower  price  levels. 

It  should  also  be  borne  in  mind  that  this  element  isjitsome 
influence  even  in  an  income  tax  su^  as  tha^in  force  in  Great 
Britain  where  appreciations  i(Lproperty  values  ar^^ot  taxec^^ 
for  an  item  of  inventory  included  in  one's  accounts  at  the 
beginning  of  the  yeaFand  sold  in  the  course  of  the  year  will 
reflect  the  change  in  the  prices  during  the  period  held. 
If  it  were  possible  to  modify  the  <^ncept  of  taxable  income  so  v| 
.  as  to  eliminate  this  variation  it  wotrld  certainly  be  desirable 
to  do  so.    The  prospect  for  a  complete  solution  of  the  difficulty 
*  pointed  out,  however,  is  identical  with  the   prospect  for  a 
perfect  monetary  standard.     But  an  approximate  solution! 
might  be  realized  if  we  were  able  to  evolve  a  satisfactory  index  • 
of  the  level  of  prices.    If  it  were  accurately  known  what  the 
change  in  price  level  in  a  given  year  had  been,  it  might  be 
possible  to  qualify  the  results  shown  by  a  comparison  of  the 
balance  sheets  for  the  beginning  and  the  end  of  the  period  in 
such  a  way  as  to  eliminate  the  influence  of  the  changing  stan- 
dard.   But  even  this  refinement  is  not  likely  to  be  introduced 
^  soon.    Indeed,  the  desirability  and  urgency  of  its  introduction 
•  IS  dependent  largely  upon  the  complete  solution  of  the  account- 
ing problem,  which  solution  is  certainly  not  imminent. 


-r 


III 


i8 


COLUMBIA  INCOME  TAX  LECTURES 


THE  CONCEPT  OF  INCOME 


19 


I 


ii 


il 


'jJ 


V2,  The  imperfections  of  accounting  practice.  The  wide  gap 
» '  which  stretches  between  theory  and  practice  in  the  field  of 
accounting  has  already  been  remarked.  Until  such  time  as 
everyone  keeps  accounts  and  the  accounts  furnish  a  perfect 
record  of  everyone's  economic  position,  the  concept  of  taxable 
income  must  be  modified  in  order  to  meet  the  problem  pre- 
sented by  the  shortcomings  of  accounting  practice.  Dozens 
of  illustrations  of  how  the  concept  is  modified  in  our  statute 
because  of  the  necessity  of  allowing  for  the  imperfections  and 
incompleteness  of  accounts  will  occur  to  everyone. 

While  the  accounting  ideal  as  stated  by  the  leading  theorists 
in  the  accounting  field  is  in  entire  harmony  with  the  economic 
analysis,  it  should  be  pointed  out  that  many  so-called  account- 
ing principles  which  are  generally  accepted  are  little   more 
than  rules  of  action  formulated  during  an  obsolete  period 
when  the  use  of  accounts  for  tax  purposes  did  not  exist.    So 
long  as  the  chief  purposes  of  the  accounts  were  to  provide  a 
basis  for  applications  for  credit,  and  for  the  distribution  of 
dividends,  rules  which  tended  toward  a  conservative  statement 
of  profits  were  certainly  full  of  virtue.    The  increase  in  the  tax 
burden  has  added  a  new  primary  use  for  the  accounts,  a  use 
which  demands  certain  qualities  which  are  not  important  in 
the  other  cases.    To  form  an  entirely  satisfactory  basis  for  the 
imposition  of  income  taxes  the  accounts  must  reflect  the  full, 
true,  economic  position  of  the  taxpayer  ;(and  in  so  far  as  arbi- 
trary  rules  of  inventory  valuations  operate  to  build  up  hidden 
reserves,  or  other  accounting  practices  tend  to  befog  the  pic- 
ture, they  must  ultimately  be  eliminated  and  they  have  no 
place  in  truly  scientific  accounting.) 

v3.  The  imperfections  of  the  administration.  ,A  .lively  regard 
for  the  limitations  of  the  administration  is  essential  to  the 
successful  formulation  of  a  tax  statute.  This  is  a  factor  which 
we^have  failed  to  recognize  sufficiently  in  this  country.  Many 
of  the  modifications  which  our  statute  makes  in  the  concept  of 
income  are  obviously  designed  to  simplify  the  problem  of 
administration,  but  in  spite  of  the  number  and  character  of 
these  modifications  there  appears  to  be  grave  question  as  to 
whether  they  have  been  sufficient  to  reduce  the  administra- 


I 


\i 


A. 


n  - 


\ 


\jr'- 


tive  task  to  manageable  proportions.  The  British,  with  their 
splendid  civil  service,  are  appalled  at  the  burden  we  place 
upon  our  inadequate  treasury  staff.  Certainly  such  changes  in 
the  abstract  definition  of  income  as  are  necessary  to  make  the 
statute  practlcaTand  workable^  must  be  accepted,  provided- 
the  cost  in  terms  of  equity  is  not  so  great  as  to  make  some 
available  alternative  tax  a  more  attractive  method  of  raising 
the  reveftue. 

In  addition  to  modifications  on  the  above  grounds,  modifica- 
tions of  two  additional  types  are  often  urged.  Those  who  are 
convinced  that  taxation  should  be  used  for  the  furtherance  of 
social  ends  often  demand  special  modifications.  For  example, 
those  who  are  deeply  impressed  with  the  desirability  of  in- 
creasing the  amount  of  economic  capital  demand  special 
treatment  of  the  individual  surplus^f  corporations,  or  reduced 
surtax  rates  upon  that  portion  of  individual  incomes  which 
are  saved  and  reinvested.  There  are  others  who  on  social 
grounds  believe  in  a  differentiation  between  earned  and  un- 
earned income. 

Again,  the  fiscal  necessities  of  the  Government  are  sometimes 
urged  as  adequate  ground  for  declining  to  bring  the  concept  of 
taxable  income  into  closer  harmony  with  the  concept  of 
economic  income,  as  in  the  case  of  the  recent  letter  of  the 
Secretary  of  the  Treasury. 

If  time  permitted  it  would  be  interesting  to  trace  the  his- 
torical evolution  of  the  concept  of  economic  income  and  of 
taxable  income  from  the  time  these  concepts  became  important 
down  to  the  present.  Only  the  barest  summary,  however,  is 
here  possible.  The  British  income  tax  places  very  heavy 
stress  upon  the  annual  character  of  income.  For  an  explana- 
tion of  this  conception,  which  results  in  the  exclusion  from 
taxable  income  of  gains  of  an  irregular  nature,  one  must  go 
back  as  far  as  the  fifteenth  century,  when,  with  an  agricultural 
society  where  few  fortuitous  gains  developed,  the  idea  of 
receipts  as  being  annual  in  character  became  deeply  impressed 
upon  the  minds  of  the  people.  It  became  the  habit  to  think  of 
one's  regular  receipts  as  his  income,  and  to  consider  irregular 
receipts  as  additions  to  capital.    Adam  Smith  spoke  of  income 


t  / 


/X* 


V 


/ 


:< 


20 


COLUMBIA     INCOME     TAX     LECTURES 


tl 


both  as  what  remains  free  after  maintaining  the  capital  and 
as  what  people  can  consume  without  encroaching  upon  their 
capital.      Ricardo   accepted    Adam    Smith's    conception   of 
economic  capital  but  protested  vigorously  against  a  concept 
of  taxable  income  which  would  include  legacies  and  even 
wages.    McCuUoch  developed  a  theory  of  differentiated  in- 
come under  which  income  from  personal  services  was  to  be 
fully  insured  in  order  to  put  it  on  a  fair  basis  as  compared 
with  the  income  from  a  building  from  which  depreciation 
allowances  had  been  subtracted.    Despairing  of  the  practica- 
bility of  such  a  proposal,  he  conclud^t|.at  income  taxation 
.i,      was  fundamentally  unfair.     John  sWart  Mill  disapproved 
U-V-  w,^v'  ,Vof  Mcculloch's  theory  of  differentiation,  but  insisted  upon 
r<  \  aP-^'  ■   exemption  for  savings.    Because  of  the  practical  difficulties  in  _ 

the  way  of  this  he  urged  a  remission  of  an  arbitrary  percentage 
of  the  income  from  "temporary"  sources."  This  is  essentially 
the  plan  which  has  been  incorporated  into  the  Italian  income 
tax  of  today.  As  has  been  noted,  Marshall  defines  income  in 
the  broadest  possible  fashion.^ 

Just  as  the  British  income  tax  has  served  as  the  model  tor 
the  various  continental  income  taxes,  so  English  writers  have 
influenced  the  thought  of  the  writers  in  other  countries     Thus 
the  German  writers  since  Schmoller  have  broken  away  from  the 
concept  of  yield  and  have  emphasized  the  subjective  concept 
These  Germans  all  agree  that  income  includes  all  goods  which 
are  placed  at  the  disposal  of  the  individual  for  the  satisfaction 
of  his  wants,  but  they  disagree  considerably  as  to  the  exact 
composition  of  that  income  and  its  relationship  to  the  concept 
of  capital.    The  idea  of  the  durability  of  the  source  plays  a 
considerable  r61e  in  their  discussions.    Schanz  calls  income 
f    the  net  inflow  of  means  during  a  given  period,  including  all 
•     usances  and  services  having  a  money  value.*" 

To  Roscher,  income  is  a  rather  restricted  category  consisting 
of  the  aggregate  of  goods  which,  arising  within  a  given  period 
of  time  as  the  yields  of  durable  sources  of  revenue,  are  at  the 

n  Heer,  op.  cit. 

«  Cf.  supra,  p.  3. 

2»  Heer,  op.  cit.  f 


THE     CONCEPT     OF     INCOME 


21 


disposal  of  the  individual  for  the  satisfaction  of  his  personal 
wants  and  those  of  his  family.  Wagner  and  his  associates, 
including  Cohn,  Newman,  and  Philippovitch,  emphasize  both 
periodicity  and  permanency  of  source.  Income  to  them  is  ,^ 
either  the  sum  total  of  goods  which  at  regularly  recurring 
intervals  flow  into  the  treasury  of  the  individual,  or  those 
commodities,  valuable  services  of  third  parties,  and  usances 
which,  as  periodic  fruits  of  permanent  productive  sources, 
flow  into  the  possession  of  the  individual  and  over  which  he 
has  absolute  control.^*  It  should  be  noted  that  here  again 
appears  the  idea  of  separation  emphasized  by  Professor 
Seligman.** 

If  this  is  what  the  foreign  writers  say  about  the  economic 
concept  of  income,  what  do  the  foreign  legislators  do  about 
establishing  the  limits  of  the  concept  of  taxable  income? 
Both  the  British  and  the  German  statutes  construct  a  concept 
much  more  narrow  than  ours.  Both  attempt  to  differentiate 
between  regular  and  fortuitous  gains.  A  British  salaried  man 
who  dabbles  in  the  stock  exchange  is  not  called  to  account 
for  his  gains  or  losses.  The  owner  of  a  residence  in  Germany 
is  not  asked  to  include  a  profit  realized  on  its  sale.  Gains  and 
losses  on  property  are  recognized  only  when  they  accrue  with 
respect  to  the  stock-in-trade  of  a  dealer.  In  Great  Britain, 
if  one  sells  his  mine  at  a  profit,  that  profit  is  not  subject  to 
income  tax,  but  neither  are  depletion  allowances  deductible 
in  making  one's  annual  returns.  The  consideration  paid  for 
a  lease  is  not  taxed,  but  depreciation  in  the  lease  may  not  be 
deducted.  The  British  do  not  tax  gains  from  appreciation  in 
the  value  of  real  estate,  which  reduces  considerably  the  signifi- 
cance of  the  late-lamented  British  Increment  Value  Duty.  As  a 
matter  of  fact,  the  effect  of  this  Duty  was  to  operate  as  a  fairly 
reasonable  income  tax  on  the  profits  from  such  transactions. 

Having  formulated  a  definition  of  economic  income,  having 
presented  the  broad  grounds  upon  which  modifications  may 
properly  be  made  in  order  to  fit  the  concept  to  the  necessities 
of  the  business  situation,  and  having  made  a  very  brief  survey 

**Ibid. 

»  Cf.  supra,  p.  8. 


■  ^f 


\ ; 


'( 


(I 


!i 


(i 


1 


V 


22         COLUMBIA     INCOME     TAX     LECTURES 

of  foreign  theory  and  practice,  let  us  examine  the  meaning 
of  the  term  income  as  used  in  the  Revenue  Act  of  191 8  to 
ascertain  how  closely  it  approaches  the  ideal  conception  of 
income.  Such  a  discussion  will  bring  clearly  to  the  fore  the 
implications  of  the  proposed  definition;  it  will  test  the  ade- 
quacy of  that  definition  to  resolve  the  anomalies  of  our  present 
practice;  and  will  raise  questions  as  to  the  desirability  of 
changes  in  our  present  statutory  concept.  ,    „  ^    ,     .    . 

The  Revenue  Act  of  1918  states  that  "there  shall  be  levied, 
collected,  and  paid  for  each  taxable  year  upon  the  net  income 
of  every  individual  (and  corporation)  a  tax."  «  Net  income  is 
defined  as  gross  income  minus  certain  specific  deductions. 
Gross  income,  in  turn,  is  described  by  specifying  certain  items 
which  it  shall  include  and  exclude.  This  establishes  the  outer, 
the  inclusive  limits.  But  it  is  apparent  that  this  merely 
describes  certain  specific  sources,  the  income  arising  from 
which  is  taxed.  In  the  familiar  language  of  the  statute,  gross 
/  income   "includes    gains,   profits,   and   income  derived   from 

salaries,  wages  or  compensation  for  personal  service  .  .  .. 
of  whatever  kind  and  in  whatever  form  paid,  or  fron^  pro- 
fessions, vocations,  trades,  businesses,  commerce,  or  sales,  or 
dealings  in  property,  whether  real  or  personal,  growing  out 
of  the  ownership  or  use  of  or  interest  in  such  property;  also 
from  interest,  rents,  dividends,  securities,  or  the  transaction 
of  any  business  carried  on  for  gain  or  profit,  or  gams  or  profits, 
and  income  derived  from  any  source  whatever." 

The  first  point  which  impresses  one  with  respect  to  our 
'>  statutory  concept  is  its  breadth  as  compared  with  thAcon- 
cepts  used  elsewhere.    It  attempts  to  draw  no  line  bel!»een 
•  •    capital  gains  and  gains  of  other  types.    It  places  no  emphasis 

^  at  all  upon  the  permanence  of  the  source  or  the  regularity  of 
\  ■  the  income.  In  its  general  scope  it  approaches  almost  to  the 
point  of  complete  identity  the  working  concept  of  profit  used 
by  the  accountant.  It  is  by  all  odds  the  most  theoretically 
perfect  income  tax  law  extant,  from  the  point  of  view  of  its 
general  scope.     Whether  it  is.  after  all,  the  most  scientific 

»  Sees.  210  and  230. 
"  Sees.  212  and  232. 


THE     CONCEPT     OF     INCOME 


23 


law  IS  another  question,  for  that  involves  the  degree  of  skill 
that  has  been  used  in  modifying  the  theoretical  concept  to 
meet  our  actual  conditions.  In  that  we  have  not  been  strik- 
ingly successful. 

It  is  interesting  to  note  the  dependence  which  our  law- 
makers are  beginning  to  place  upon  the  accountants  and  their 
standards  of  practice.  The  191 8  law,  for  the  first  time,  specifi- 
cally directs  that  certain  results  be  reached  by  methods  in 
accordance  with  accepted  accounting  procedure.  This  appears 
to  be  the  modern  tendency  and  is  certainly  a  laudable  one. 
Thus  the  German  Excess  Profits  Law  passed  in  191 5  is  an 
exceedingly  simple  document  which  meets  the  whole  problem 
of  defining  profits  by  stating  that  they  shall  be  taken  to  be  the 
"balance  of  profit  duly  reckoned  in  accordance  with  the  legal 
prescriptions  and  recognized  principles  and  methods  of  mer- 
cantile^ccounting."  ** 

The  net  income  which  our  1918  Act  attempts  to  reach  is  in  ^' 
the  main  money  income.  There  are  these  exceptions:  (i) 
There  is  a  specific  provision  to  the  effect  that  income  from 
personal  services  "of  whatever  kind  and  in  whatever  form 
paid"  2*  shall  be  accounted  for.  (2)  Stock  dividends  are 
declared  taxable  but  this  declaration  is  nullified  by  the  recent 
decisions  of  the  Supreme  Court. '°  (3)  In  the  case  of  exchanges, 
the  property  received  in  exchange  is  "treated  as  the  equivalent 
of  cash  to  the  amount  of  its  fair  market  value,  if  any,"  *^  with 
the  qualification  that  in  the  case  of  reorganizations  the  trans- 
actions are  not  closed  in  case  the  par  value  of  the  securities 
received  in  exchange  for  the  old  securities  is  not  in  excess  of  the 
securities  surrendered. 

^/*-It  will  be  recalled  that  our  definition  demands  the  taxation  '  'J 
of  the  net  accretion  of  one's  power  measured  in  money  or^/ 
money-worth.    Should  the  statute  go  further  than  it  does  in  | 
taxing  real  income  even  when  received  in  some  form  other  t 
than  money?    The  problem  is  largely  an  administrative  one.  n 
The  specific  case  of  the  income  one  really  receives  when  he  " 

*•  Reichs  Cesettblatt,  No.  187.  Year  1915. 
"Sec.  a  13. 
♦  .••  Cf.  supra,  p.  8. 
"  Sec.  202  (b). 


/ 


X 


^ 


) 


\ 


24 


COLUMBIA  INCOME  TAX  LECTURES 


THE  CONCEPT  OF  INCOME 


25 


i 


^i 


11 


II 


li 


)' 


lives  in  the  house  he  himself  owns  has  become  rather  acute, 

the  favored  position  of  such  an  owner  being  vigorously  used 

by  real-estate  promoters,  particularly  those  interested  m  the 

sale  of  high-class  apartment  buildings  on  the  cooperative  plan. 

Such  real  income  should  certainly  be  taxed  if  it  is  practicable 

I  to  evaluate  it.    The  present  position  is  anomalous,  particularly 

\  when  one  remembers  that  such  owners,  while  they  may  not 

\  deduct  insurance  and  upkeep,  may,  nevertheless,  deduct  the 

y/  <  taxes  on  the  property  and  the  interest  on  any  money  they 

may  have  borrowed  to  carry  the  property.     The  way  to 

remove  the  anomaly  is  to  approach  the  definition  of  income 

more  closely  in  practice.  , 

The  statute  includes  as  taxable  income  appreciations  ot 
property  values,  whether  those  appreciations  are  in  stock-in- 
trade,  in  capital  assets,  or  in  miscellaneous  bits  of  property 
owned  incidentally.    In  this  it  has  the  sanction  of  ouj  defini- 
tion.   A  distinct  departure  is  made  from  the  definition,  how- 
ever, by  the  practice  of  taxing  those  appreciations  only  irregu- 
larly as  sales  are  consummated,  and  at  the  rates  in  force  in  the 
year  during  which  the  consummation  occurs.    This  practice 
lies  at  the  root  of  the  present  widespread  dissatisfaction  with 
the  taxation  of  appreciations.    Our  definition  demands  their 
taxation  whenever  they  become  susceptible  of  a  definite 
evaluation.     A  scheme  of  arbitrary  apportionment  of  the 
gain  over  the  period  of  accrual  would  be  infinitely  superior  to 
the  present  practice.    With  rates  varying  as  they  have  dunng 
the  past  few  years,  there  has  been  a  tremendous  incentive  to 
the  business  man  to  resort  to  methods  of  postponing  the 
closing  of  his  transactions.    The  tax  on  appreciations  has  in 
fact  operated  as  a  substantial  force  restraining  the  alienation^ 

of  property.  u    *-    1 

So  long  as  our  accounting  methods'are  not  equal  to  the  task 
of  furnishing  a  complete  revaluation  of  assets  at  the  beginning 
and  the  close  of  each  accounting  period  there  is  no  comf^ete 
solution  to  this  problem.  However,  unless  the  admimstrative 
burden  of  the  plan  of  arbitrary  apportionment  of  gains  actual  y 
made  at  times  of  sale  is  too  great  to  be  borne,  that  plan  should 
certainly  be  given  a  trial. 


% «« 


Too  much  importance  may  easily  be  attached  to  British 
precedents  in  determining  whether  gains  from  appreciations 
in  property  values  should  or  should  not  be  included  within 
the  definition  of  income.  The  British  concept  of  taxable 
income,  which  excludes  such  gains,  is  a  product  of  a  prac- 
tical local  situation  which  differs  in  essential  respects  from  our 
own.  The  exclusion  of  such  gains  is  acknowledged  to  be  illogi- 
cal and  was  the  cause  of  much  evasion  of  the  Excess  Profits 
Duty.  In  fact  in  the  administration  of  that  Duty  it  was  found 
necessary  to  make  important  modifications  in  the  direction  of 
the  acknowledgment  of  capital  gains  and  losses  as  factors  in  the 
determination  of  income.^^  Finally  the  Report  of  the  Royal 
Commission  on  the  Income  TaXy  recently  submitted,  not  only 
recommends  the  recognition  of  depletion  to  a  limited  extent 
but  urges  that,  hereafter,  gains  from  incidental  business  trans- 
actions, even  where  the  property  which  appreciates  is  not 
worthy  of  the  designation  of  "inventory,"  be  included  within 
the  scope  of  taxable  income.^ 

There  is  an  interesting  incidental  point  in  connection  with 
this  problem.  We  have  been  accustomed  to  consider  the » 1 
income  tax  as  one  of  our  elastic  taxes  whose  rates  may  be 
conveniently  varied  to  meet  the  needs  of  a  variable  budget. 
Has  not  our  recent  experience  with  our  income  tax  which  taxes 
appreciation  shown  that  with  an  income  tax  of  this  type 
variable  rates  must  be  avoided  until  the  day  of  perfect  account- 
ing arrives?  If  the  business  man  were  certain  that  present 
rates  would  continue  indefinitely,  the  present  game  of  post- 
poning realizations  would  quickly  cease.  On  the  other  hand^ 
it  may  be  well  to  meet  this  problem  by  adopting  the  British 
procedure  of  taxing  business  profits  on  the  basis  of  an  average 
of  previous  years. 

The  present  statute  does  not  regard  gifts  received  by  indi-u 
viduals  as  taxable  income.    Ordinarily  gifts  may  not  be  sub- 1 
tracted  in  arriving  at  the  taxable  income  of  the  giver,  but  chari-\ 
table  contributions  made  to  certain  corporations  may  be  de- 
ducted by  an  individual,  subject  to  a  fifteen  per  cent,  limitation. 

"  Cf.  Haig.  The  Taxation  of  Exuss  Profits  in  Great  Britain,  1920,  pp.  69-73  et  passim. 
"  Cmd.  615,  p.  20  et  seq.,  p.  41,  e<  seq. 


0  0 


ill 


I 


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I  i 


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SI 


I 

1 

I 


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26         COLUMBIA     INCOME     TAX     LECTURES 

f  Until  recently  the  Treasury  permitted  such  an  individual  to 
I  deduct  from  his  taxable  income  the  value  of  the  gift  when 
made.  This  procedure,  however,  has  been  changed  and  he 
may  now  subtract  merely  the  original  cost  or  the  value  on 
March  i,  1913,  if  purchased  before  that  date.  Gifts  to 
relatives  of  property  upon  which  one  wishes  to  realize  are 
becoming  a  common  method  of  evasion,  for  profit  to  the 
recipient  is  measured  from  the  value  of  the  gift  at  time  of 

receipt.  .  ,      r  -e^ 

In  view  of  suggested  legislative  action  with  reference  to  gifts 
it  is  of  interest  to  consider  them  in  relation  to  the  definition  as 
developed  above.    Are  gifts  income?    Under  the  terms  of  the 
'^  definition,  they  are  if  they  increase  the  economic  strength  of 
the  recipient.     But  most  gifts^^are  either  to  relatives  or  to 
charitable  institutions.   With  respect  to  family  gifts  a  case  may 
be  made  out  for  ignoring  the  transfer  of  title  on  the  ground 
of  the  essential  economic  unity  of  the  family.    The  family,  as 
a  matter  of  fact,  is  even  now  tp  a  considerable  extent  the  basic 
unit  for  income  tax  purposes.    Gifts  to  charitable  institutions 
are  now,  within  the  fifteen  per  cent.^  limit,  deductible  to  the 
\  giver  and  exempt  to  the  recipient..  On  the  ground  of  public 
policy  much  can  be  said  for  continuing  this  practice  although 
it  is  also  true  that,  speaking  in  terms  of  economic  fundamentals, 
the  man  who  makes  a  gift  to  some  person  or  corporation  out- 
side his  immediate  family  deliberately  chooses  that  way  of 
spending  his  money  because  it  yields  him  a  greater  satisfaction 
than  some  alternative  use..  In  any  case  appreciations  in  the 
property  given  away  would,  under  the  proposed  definition, 
become  taxable  gradually  as  they  emerged  in  definite  enough 
form  to  be  susceptible  of  an  evaluation. 

In  summary,  then,  it  must  be  apparent  that  the  differences 
u  among  economists  as  to  the  definition  of  income  are  really  , 
more  on  questions  of  policy  than  on  questions  of  pnnciple. 
There  is  substantial  agreement  as  to  its  fundamental  char- 
acter, but  some  disagreement  as  to  how  far  the  definition  ought 
to  be  narrowed  so  as  to  make  it  useful  for  purposes  of  an  in- 
come tax  base. 


THE     CONCEPT     OF     INCOME 


27 


/ 


The  formal  definition  of  economic  income,  which,  in  the 
opinion  of  the  writer,  provides  the  most  acceptable  concept 
of  income,  may  be  stated  as  follows:  Income  is  the  money-  I 
value  of  the  net  accretion  to  economic  power  between  two  points 
of  time.  This  definition  cannot  be  written  into  a  statute  in 
literal  form  because  of  the  technical  disadvantages  in  deter- 
mining income  as  so  defined,  but  so  long  as  taxable  income 
differs  appreciably  from  this  definition  there  will  be  anomalies 
and  injustices  in  income  taxation,  and  every  step  marking 
a  closer  approximation  of  this  definition  will  result  in  the 
elimination  of  irregular  and  eccentric  results. 

The  concept  of  taxable  income  is  a  living,  mutable  concept 
which  has  varied  widely  from  time  to  time  and  from  country 
to  country  with  the  conditions  under  which  it  has  had  to 
operate. 

The  concept  as  it  stands  in  our  own  law  is  probably  the\ 
closest  approach  to  true  economic  income  yet  achieved  by 
any  country.  The  primary  limiting  factors  are  our  varying 
I  level  of  prices,  our  inadequate  accounting — including  imper- 
f{  fections  of  valuation,  and  our  incompetence  of  administration. 
Possibilities  of  further  progress  depend  primarily  upon  our 
ability  to  improve  our  standard  of  value,  our  accounting, 
and  our  administration. 

It  is  very  undesirable  from  the  point  of  view  of  economics 
and  equity  that  the  judicial  definition  of  income  should 
develop  along  narrow  lines  by  the  process  of  definitely  elim- 
inating from  the  concept  certain  items  as  not  being  income. 
The  real  question  is  not  often  "Is  the  item  income?"  but  rather 
"Is  the  method  used  for  reaching  this  class  of  income  justified?" 
In  other  words,  have  Congress  and  the  Treasury  provided 
an  equitable  answer  to  the  practical  question  as  to  how  and 
when  such  income  shall  be  taxed,  taking  into  account  the 
imperfections  of  the  situation  in  which  the  tax  must  function? 
Under  a  given  statute,  is  income  taxed  at  such  times  and 
in  such  a  manner  as  to  bring  about  the  necessary  degree  and 
the  highest  practicable  degree  of  equity  to  the  taxpayer  and^^ 
between  taxpayers?  The  definition  of  income  should  rest  on 
fundamental  economic  principles.     The  definition  must  be 


^  V. 


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.-^ 


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28    COLUMBIA  INCOME  TAX  LECTURES 

broad  enough  to  iron  out  all  the  theoretical  difficulties  and 
solve  all  of  the  inequities  and  anomalies.  The  situation  should 
be  held  in  a  mobile,  flexible  state  which  will  permit  the  statu- 
tory definition  of  income  to  become  progressively  more  pre- 
cise and  accurate  with  the  improvement  of  the  technique  of 
our  economic  environment.  | 


w 


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AVHEN  IS  INCOME  REALIZED? 

BY 

Thomas  S.  Adams,  Ph.D. 

When  is  income  realized  in  the  case  of  taxpayers  making 
return  upon  the  so-called  cash  or  receipts  basis?  Or,  to  begin 
with  a  more  concrete  case  under  this  general  head — is  income 
realized  or  received  when  goods  or  services  are  sold  on  open 
account  or  on  the  personal  credit  of  the  purchaser  and  the 
taxpayer  receives  nothing  more  tangible  than  a  mere  claim 
or  chose  in  action? 

A  few  words  may  profitably  be  said  in  advance  about  the 
method  of  approaching  this  subject  or  the  terms  in  which 
it  can  best  be  discussed.  The  only  income  under  discussion 
at  this  point  is  "income  received."  But  it  is  now  well  estab- 
lished that  income  need  not  be  in  the  form  of  money  or  cash ; 
it  is  only  necessary  that  the  thing  received  shall  be  the  equiva- 
lent of  cash.  As  has  been  well  said,  "Returnable  and  taxable 
income  is  that  actually  realized  during  the  year,  evidenced 
by  the  receipt  of  cash  or  its  equivalent."  ^  This  principle 
of  "cash  equivalence"  would  seem  to  provide  a  ready,  incisive 
test  of  universal  application.  Has  something  been  received 
(on  income  or  revenue  account,  of  course)  and  is  it  in  fact 
the  equivalent  of  cash?  If  so,  it  is  taxable.  If  not,  the  account- 
ing for  taxation  must  be  deferred. 

But  the  subject  has  not  been  handled  in  this  simple  and 
elegant  way  either  by  the  courts  or  the  Treasury.  It  would 
be  possible  to  give  a  long  list  of  cases  or  questions  which  have 
been  settled  by  the  courts  or  by  the  Treasury  without  any 
reference  apparently  to  the  question  whether  the  credit, 
claim  or  chose  in  action  was  in  fact  the  equivalent  to  cash. 

*  Mimeograph  letter  to  CoUectora  explaining  T.  D.  2005,  dated  August  14,  1914. 


-'"  --^ 


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30         COLUMBIA     INCOME     TAX     LECTURES 

Indeed  in  practical  effect,  the  Treasury  goes  so  far  apparently 
as  to  regard  some  payments  in  specie  as  unrealized  mcome: 
"rents  received  in  crop  shares  shall  be  returned  as  of  the  year 
in  which  the  crop  shares  are  reduced  to  money  or  money 
equivalent."     The    regulations    dealing   with    sales    on    the 
instalment    plan «     supply    another    important    instance    m 
which  the  Treasury  has  in  effect  disregarded  or  at  least  con- 
ventionalized the  test  of  cash  equivalence.     It  thus  appears 
necessary  to  approach  this  subject  in  ways  more  realistic 
and  roundabout  than  the  simple  path  offered  by  the  test 
of  cash  equivalence.    Each  case  or  class  of  cases  must  be  settled 
on  its  merits,  on  its  own  peculiar  facts.     We  must  proceed 
inductively;    and  it  will  be  profitable,  I  believe,  first  of  all 
to  consider  the  most  important  class  of  cases,  that  of  tax- 
payers engaged  in  manufacturing,  merchandising,  and  mining 
who  pay  one  year  with  another  probably  sixty  per  cent,  of 
all  the  income  taxes  collected  in  the  United  States. 

Manufacturing,  Merchandising  and  Mining 

Business 

In  the  case  of  taxpayers  engaged  in  merchandising  or  manu- 
facturing, the  issue  here  under  discussion  has  been  conscious 
and  acute  from  the  very  beginning.    Indeed  it  was  raised  in 
an  important  way  before  the  passage  of  the  special  excise 
tax  (with  respect  to  corporation  income)  of  August  5,  1909- 
Under  date  of  July  8,  1909,  twelve  of  the  most  prominent 
firms  of  accountants  of  the  country  in  a  carefully  framed 
communication  addressed  to  George  W.  Wickersham,  Attor- 
ney General,  vigorously  protested  that  the  phraseology  of  the 
proposed  law,  dealing  with  "income  received"  and  ''expenses 
actually  paid,"  was  unsuited  to  modern  business,  "that  the 
law  as  framed"  was  "absolutely  impossible  of  application,"  and 
suggesting  that  "the  words  'actually  paid'  and  'actually  sus- 
tained' be  changed  to  read  'actually  incurred'  and  'actually 
ascertained'  .     .     •"    This  correspondence  with  the  Attorney 
General  well  repays  careful  reading.      In  a  second  letter 

« Reg.  45.  Art.  42-46. 


WHEN     IS     INCOME     REALIZED 


31 


dated  July  21,  1909,  the  accountants  suggest  that  it  would  be 
"better  to  use  the  term  'receipts  on  income  account'  and  'dis- 
bursements on  income  account*  rather  than  'income'  and  'ex- 
pense,' as  the  latter  terms  are  more  commonly  defined  and 
used  in  relation  to  income  earned  and  expenses  incurred." 
And  they  stated  the  reasons,  in  technical  accounting  phrase- 
ology, which  prove  that  in  the  case  of  a  large  manufacturing 
concern  it  is  a  practical  impossibility  to  compute  on  a  strictly 
receipts  basis  the  amount  of  net  income. 

In  answer  to  these  representations  the  Attorney  General 
replied  that  "the  bill  was  purposely  framed  to  deal  with 
receipts  and  disbursements  made  within  the  year  for  which 
the  tax  was  to  be  imposed,  and  the  words  'actually  paid'  were 
employed  advisedly.  The  same  may  be  said  with  respect  to 
losses  actually  sustained  and  interest  actually  paid.  The 
theory  of  the  framers  of  the  bill  in  this  respect  differs  from 
that  which  you  advocate."  This  theory  finally  prevailed. 
The  bill  as  adopted  was  couched  in  terms  of  income  received 
and  expenses  paid. 

Notwithstanding  the  deliberate  rejection  of  the  suggestions 
of  the  accountants  in  question,  both  by  the  Attorney  General 
and  by  the  committees  of  Congress  charged  with  the  duty  of 
formulating  the  law,  and  notwithstanding  the  fact  that  the 
Government  had  no  particular  pecuniary  interest  in  deciding 
this  question  one  way  or  the  other  (inasmuch  as  in  the  long 
run  a  strict  cash  accounting  would  yield  approximately  the 
same  revenue  as  an  accrual  accounting  and  probably  a  little 
more),  the  regulations  adopted  the  theory  of  the  accountants 
and  not  that  of  the  Attorney  General.  Taxpayers  of  this 
class  were  required  to  compute  gross  income  received  "through 
an  accounting  that  shows  the  difference  between  the  price 
received  for  the  goods  sold  and  the  cost  of  such  goods  as 
manufactured,"   and  it  was  further  stated : 

It  IS  immaterial  whether  any  item  of  gross  income  is  evidenced  by 
cash  receipts  during  the  year  or  in  such  other  manner  as  to  entitle  it 
JO  proper  entry  on  the  books  of  the  corporation  from  January  i  to 
December  31  for  the  year  in  which  return  is  made.' 

•  Reg.  No.  31,  dated  December  3.  1909.  Art.  2,  par.  3.  4.  S  and  Art.  4. 


If'. 


1 

s 


y»i.     .  ■.._^.'B^^'J» 


.1 


32         COLUMBIA     INCOME     TAX     LECTURES 

It  is  not  necessary  here  to  follow  in  detail  the  subsequent 
regulations   and   rulings   of   the  Treasury  relating  to  com- 
putation of  income  received  by  such  taxpayers.     Under  all 
the  income  tax  laws,  they  have  consistently  and  practically 
without   exception   required   taxpayers  to  compute  mcome 
on  the  basis  of  total  sales,  whether  the  sale  price  had  been 
actually  received— or  the  payments  actually  made-or  not. 
Of  course  no  taxpayer  has  been  compelled  to  include  m  his 
gross  income  claims  or  accounts  receivable  which  were  not 
the  equivalent  of  cash.     "Debts  ascertained  to  be  worthless 
and  charged  off  within  the  taxable  year"  could  be  subtracted; 
and  in  the  language  of  present  regulations  * : 

If  a  taxpayer  computes  his  income  upon  the  basis  of  valuing  Ws 
notes  or  l^counts  receivable  at  their  fair  market  value  when  receiv^. 
ThTch  may  be  less  than  their  fair  market  value,  the  amount  deductible 
for  bad  debts  in  any  case  is  limited  to  such  original  valuation. 

Yet  it  is  true  in  substance  that  from  the  adoption  of  the 
special  excise  tax  of  August  5,  1909.  with  respect  to  the  most 
important  class  of  taxpayers  subject  to  the  tax,  accounts 
receivable  and  bills  receivable  have  been,  compulsonly. 
treated  as  income  received  at  the  time  set  up  or  accepted  unless 
it  could  be  demonstrated  that  they  were  not  the  equivalent  of 

pash 

Why  in  the  case  of  manufacturing  and  merchandising  did 
the  Treasury  depart  so  radically  from  the  views  expressed  by 
Attorney  General  Wickersham?  As  stated  above,  the  Govern- 
ment had  no  greater  pecuniary  interest  in  one  interpretation 
than  the  other.  The  Treasury  endeavors  in  good  faith- 
according  to  my  experience— to  accept  and  enforce  the  real 
intent  of  Congress  as  revealed  in  the  language  of  the  statute. 

First  of  all  it  may  be  noted  that  the  interpretation  of  the 
law  implicit  in  the  regulations  was  urged  upon  the  Treasury 
by  the  business  interests  concerned.  It  was  the  convenient 
and  practical  way  of  computing  net  income.  It  may  be  added 
that  this  regulation  has  never  been  questioned  in  the  courts, 

«Art.  iSi. 

•  LT.  S.,  1916,  H  iioi.p.  313. 


WHEN     IS     INCOME     REALIZED 


33 


so  far  as  I  know,  and  has  never  been  the  subject  of  protest 
from    the   taxpayers   of   the   country. 

As  a  matter  of  mere  language,  moreover,  the  regulations 
prescribe  the  procedure  followed  by  a  very  large  majority  of 
mercantile  and  manufacturing  concerns  in  computing  the 
thing  which  is  commonly  called  "income,"  the  income  which 
they  report  to  their  bankers  and  (in  the  case  of  corporations) 
to  their  stockholders.  It  has  been  repeatedly  held  that  the 
word  income  as  used  in  the  Sixteenth  Amendment  and  the 
statutes  enactCHj  in  pursuance  thereof  has  been  used  in  its 
common  ordinary  meaning.  The  letter  of  the  accountants 
referred  to,  under  date  of  July  21,  1909,  bears  unconscious 
and  very  valuable  evidence  of  the  common  ordinary  meaning 
of  the  word  income  as  used  in  connection  with  manufacturing 
and  mercantile  accounts: 

^  Under  th^  circumstances  it  would  seem  better  to  use  the  term 
receipts  on  income  account"  and  "disbursements  on  income  account" 
rather  than  "income"  and  "expense,"  as  the  latter  terms  are  more 
commonly  defined  and  used  in  relation  to  income  earned  and  expenses 
incurred. 

In  short  the  word  income  in  manufacturing  and  mercantile 
business  carries  usually  and  inevitably  certain  accrual  implica- 
tions. In  businesses  of  any  magnitude  it  is  the  only  basis  for 
computing  net  income  which  is  practicable  or  possible.  The 
concept  in  the  mind  of  Attorney  General  Wickersham  is 
connoted  by  the  word  receipts  or  gross  receipts,  not  by  the 
word  income. 

The  reasons  for  the  preceding  statement  may  be  easily  seen. 
The  income  of  the  average  manufacturing  or  mercantile 
business  consists  principally  of  profits.  To  compute  profits 
there  must  be  a  deduction  of  the  cost  of  the  thing  sold  from 
the  amount  for  which  it  has  been  sold.  In  the  multitudinous 
transactions  of  the  average  mercantile  or  manufacturing 
business,  however,  costs  must  be  computed  in  the  aggregate, 
for  a  volume  of  business  occurring  during  a  specified  period  of 
time,  by  the  use  of  inventories  and  similar  devices.  (The  case 
»s,  of  course,  quite  different  for  major  items  of  capital,  cost 
records  for  which  are  separately  kept).    The  only  time  that 


!( 


M! 


i:,' 


34 


COLUMBIA     INCOME     TAX     LECTURES 


■!      ' 


aggregate  costs  can  be  accurately  computed  is  during  or  at  the 
end  of  the  accounting  period  in  which  the  sales  are  made. 
It  is  impracticable  to  subtract  costs  at  the  time  collections  are 
made.  Collections  string  along  over  long  and  different  periods 
of  time,  purchasers  frequently  pay  in  one  check  for  goods  or 
services  bought  in  different  years  or  different  accounting 
periods.  In  short,  for  fairly  obvious  reasons,  modern  business 
cannot  measure  its  income  on  the  basis  of  collections  minus 
the  costs  and  expenses  assignable  to  the  goods  and  services 
paid  for  but,  on  the  contrary,  must  make  the  reckoning  during 
or  for  the  accounting  period  in  which  the  sales  are  made, 
treating  book  accounts,  bills  receivable  and  like  credits  as 
items  of  true  income — property  received  in  exchange  for 
property  or  service  rendered — and  treating  the  similar 
obligations  assumed  by  the  taxpayer  as  items  of  real  expense 
or  outgo. 

Expressed  in  the  language  of  accounting  the  considerations 
alluded  to  above  were  thus  formulated  in  the  letters  of  the 
accountants  mentioned  to  Attorney  General  Wickersham : 

Turning  now  from  this,  which  is  perhaps  the  most  simple  case,  to 
that  of  a  large  manufacturing  concern  producing  all  kinds  of  finished 
products  out  of  purchases  of  ore  and  other  raw  materials,  an  accurate 
or  even  approximate  statement  of  cash  receipts  and  disbursements  on 
income  account  is  a  practical  impossibility  at  any  time.  Cash  receipts 
arising  from  sales  of  products  can  be  ascertained  without  much  dif- 
ficulty, beyond  requiring  considerable  extra  work.  But  no  system  of 
accounting  can  give  even  approximately  "the  ordinary  and  necessary 
expenses  actually  paid  within  the  year  out  of  income  in  the  mainte- 
nance and  operation  of  its  business  and  properties."  Such  expenses 
presumably  must  include  the  cost  of  the  goods  sold.  Into  this  cost 
and  following  it  through  the  intricate  accounting  which  has  been  found 
to  be  necessary  are  raw  materials  actually  used  in  manufacture,  labor 
expended,  and  innumerable  items  of  expense,  which  are  taken  into  costs 
as  they  accrue  quite  irrespective  of  the  date  of  payment.  Very  large 
inventories  are  carried  of  materials  and  supplies  which  are  purchased  at 
one  period,  paid  for  at  another,  and  used  at  all  sorts  of  times,  in  all 
sorts  of  quantities,  and  for  all  sorts  of  purposes,  mainly  for  manufacture 
into  products  for  sale,  but  to  a  large  extent  for  additions  to  or  exten- 
sions of  the  plant.  Such  as  are  used  for  the  latter  purpose  are  not, 
as  we  understand  the  proposed  law,  a  proper  deduction  from  gross 
income,  and  yet,  long  before  they  are  used  all  identity  between  the 
materials  themselves  and  the  disbursements  made  for  them  has  been 
lost.  There  is,  in  our  opinion,  no  method  in  which  any  statement  such 
as  that  called  for  in  the  proposed  law  can  be  prepared  short  of  an 


WHEN     IS     INCOME     REALIZED 


35 


entirely  independent  and  separate  set  of  books,  designed  to  follow  each 
bill  paid  through  to  the  ultimate  destination  of  the  materials  or 
services  covered  thereby,  thus  duplicating  the  present  cost  of  the 
accounting  department  and  serving  no  useful  purpose  whatever. 
Even  if  such  method  were  adopted,  it  is  very  doubtful  if  it  would 
produce  the  results  required  with  even  approximate  accuracy. 

I  have  elaborated  at  undue  length  perhaps  the  point  here 
under  discussion.  But  the  gravity  of  the  situation  justifies 
the  space  devoted  to  the  subject.  The  courts  have  recently 
in  an  increasing  number  of  cases  repeated  with  approval  the 
finding  in  United  States  v.  Schillinger «:  "In  the  absence  of 
any  special  provision  of  law  to  the  contrary,  income  must  be 
taken  to  mean  money,  and  not  the  expectation  of  receiving  it, 
or  the  right  to  receive  it,  at  a  future  time."  This  means  if 
applied  literally  to  returns  of  merchants  and  manufacturers 
that  most,  and  the  most  important,  assessments  made  under 
laws  prior  to  the  Revenue  Act  of  1918  are  invalid.  To 
attempt  to  correct  these  assessments  would  cause  grave  con- 
fusion and  it  would  subject  the  taxpayers  concerned  to  other 
real  hardship. 

Prior  to  1919  federal  tax  rates  rose  rapidly.  Collections 
followed  sales  in  point  of  time.  Much  of  the  war  profit,  so- 
called,  was  taxed  at  the  lower  rates  applicable  to  the  years  in 
which  the  sales  were  made.  If  these  profits  must  be  taxed  in 
the  year  in  which  collections  were  made  the  taxes  would  be 
very  much  heavier.  And  the  situation  does  not  correct  itself 
at  the  other  end.  By  the  time  tax  rates  were  reduced  accrual 
accounting  was  formally  entrenched  in  the  tax  law.^  The 
conclusion  which  I  believe  to  be  sound  and  which  I  deeply  hope 
will  commend  itself  to  the  wisdom  of  the  courts  is  that,  in 
mterpreting  the  words  "income  received,"  trade  practice  and 
procedure  should  be  followed  when  a  prevailing  trade  prac- 
tice may  be  fairiy  said  to  be  discoverable.  I  believe  there  is 
no  such  established  practice  in  the  treatment  of  income  de- 
rived from  sales  of  personal  service  on  which  the  courts  have 
already  spoken,  but  there  is  a  prevailing  practice  among 
merchants  and  manufacturers  and  it  is  that  which  is  embodied 

•  14  Blatchf.,  27  Fed.  Case  No.  i6,  341. 
'  1918  law.  Sec.  212. 


r 


.  I 


36         COLUMBIA     INCOME     TAX     LECTURES 

in  the  regulations.  Expressed  in  terms  of  the  doctrine  of 
"cash  equivalence"  Hhe  conclusion  seems  to  be  that  the  receiv- 
ables and  other  claims  created  in  the  course  of  an  ordinary 
mercantile  or  manufacturing  business  are  in  fact  and  should  be 
treated  as  the  "equivalent  of  cash,"  unless  and  to  the  extent 
that  the  contrary  is  shown.  That  they  are  the  equivalent  of 
cash  is  proved  (i)  by  the  small  percentage  of  uncollectible  or 
bad  accounts  found  in  the  average  business,  (2)  by  the  willing- 
ness if  not  the  obvious  desire  of  this  class  of  taxpayers  to  pay 
on  the  basis  prescribed  by  the  regulations,  and  (3)  by  the  whole 
purpose  and  object  of  business  which  is  to  exchange  goods  or 
services  for  cash  or  credit,  and  usually  for  credit  rather  than 
cash. 

Instalment  Sales,  Farming,  Contracting  and 
Construction  Companies 

In  the  case  of  merchants  and  manufacturers,  income  is 
principally  profit;  profit  cannot  be  computed  without  deduct- 
ing cost  of  sales;  the  only  practical  way  of  computing  the 
latter  is  through  the  use  of  inventories  or  their  equivalent; 
inventories  can  be  taken  only  at  the  end  of  the  accounting 
period  (usually  perhaps  a  year),  and  this  forces  the  computa- 
tion of  income  or  profit  to  be  based  on  the  sales  of  the  account- 
ing period  whether  the  corresponding  accounts  have  been 
actually  collected  or  received  within  that  accounting  period 
or  not.     This,  as  I  consider  it,  is  the  necessary  logic  of  the 
situation.    This  logic  has  found  expression  in  the  prevailing 
trade  or  commercial  practice,  and  the  departmental  regula- 
tions relating  to  merchants  and  manufacturers  thus  rest — 
I  trust  they  will  be  found  eventually  to  rest  securely  both  as 
a  matter  of  law  and  equity — on  the  two  pillars  of  commercial 
logic  and  commercial  practice.    Where  either  of  these  supports 
is  lacking  the  regulations  and  rulings  of  the  Treasury  usually 
permit  the  taxpayer  to  report  on  the  cash  or  receipts  basis; 
and    where  the  doctrine   of   the  Treasury  has   changed  or 
evolved  it  has  usually  been  in  the  direction  of  a  wider  accept- 
ance of  the  cash  or  receipts  basis. 

•  1918  law,  Sec.  202  (b). 


WHEN     is     income     REALIZED 


37 


Instalment  Sales  and  Sales  Involving  Deferred  Payments, 
Until  the  issuance  of  Regulations  45  relating  to  the  Revenue 
Act  of  1918,  the  Treasury  appears  to  have  held  consistently 
that  profits  arising  from  such  sales  must  be  reported  in  the 
year  in  which  the  sale  was  made,  i,  c,  when  the  title  passed. 
Under  existing  regulations,  however,  taxpayers  are  given 
a  wide  option.  In  this  case  a  compulsory  non-cash  method 
has  been  replaced  by  an  optional  cash  method,  and  this 
is  not  due  to  the  passage  of  new  legislation,  since  the 
change  in  the  law  has  been  in  the  opposite  direction,  i.  e., 
towards  the  strengthening  of  accrual  accounting  for  tax 
purposes. 

T.D.  2090  (December  14,  1914)  contains  under  the 
caption  "Profit  from  sale  of  real  estate"  the  following  para- 
graph : 

For  income  tax  purposes,  where  there  is  an  actual  sale  and  transfer, 
profit  will  be  considered  as  realized  even  though  payment  is  to  b^ 
made  in  instalments,  as  notes  for  deferred  payments  are  secured  by 
the  title  to  the  property,  and  presumably  bear  interest  and  are  held 
to  be  worth,  in  cash,  their  face  value. 

In  Regulations  No.  33  (Revised)  governing  the  collection 
of  the  income  tax  imposed  by  the  Act  of  September  8,  1916 
as  amended  by  the  Act  of  October  3,  1917,  the  above  doctrine 
was  retained  for  instalment  sales  of  personal  property  and 
real  estate  in  which  title  passed  at  the  time  of  the  sale,  but 
the  cash  instalment  method  was  recognized  for  such  sales 
when  title  remained  in  the  vendor  until  the  contract  price 
was  fully  paid.® 

Under  existing  regulations  the  test  based  upon  passage  of 
title  has  been  practically  disregarded  with  respect  to  sales 
both  of  real  estate  and  personal  property  where  initial  pay- 
ments of  a  substantial  nature  are  not  made,  and  within  wide 
limits  the  taxpayer  is  given  an  option  either  to  return  the 
entire  profit  when  the  sale  is  originally  made  or  to  report 
profit  ratably  as  the  actual  cash  collections  are  made.^o 
he  rule  or  test  employed  in  the  regulations  is  whether  the 

1*.%  ^**'  ^°'  ^^  ^^^^'•^<l).  Aru.  n6.  117.  and  120. 
W-  Reg.  45.  Arts.  42,  44,  45.  and  46. 


I 

I 


I 


38         COLUMBIA     INCOME     TAX     LECTURES 

obligations  assumed  by  the  purchasers  or  buyers  "are  ordi- 
narily to  be  regarded  as  the  equivalent  of  cash."    The  use  of 
the  word  "ordinarily"  here  is  very  significant.     The  test  is 
not  applied  in  each  individual  case  but  the  rule  is  based  upon 
the  general  character  of  this  class  of  sales  as  determined  by 
experience  and  as  exemplified   in  the  accounting  methods 
of  taxpayers  engaged  in  this  class  of  business.    A  taxpayer 
would  consequently  be  entitled  to  use  the  ratable  cash  basis 
here  even  though  in  a  particular  sale  the  obligations  assumed 
by  the  buyer  were  unquestionably  the  equivalent  of  cash." 
Farming.     Farming  affords  an  illustration  of  a  business 
in  which   the   "necessary  logic"  would   perhaps  require  an 
accounting  on  the  basis  of  sales  as  distinguished  from  receipts, 
but  as  the  accounting  practice  (or  lack  of  practice)  in  this 
business  would  not  justify  such  a  requirement,  the  Treasury 
Department  has  accepted   from  the  beginning  the  crudest 
forms  of  cash  accounting,  although   as  early  as  February 
12,  1915/^  "farmers  who  keep  books  according  to  some  method 
of  accounting"  were  given  the  most  liberal  option  to  "prepare 
their  returns  from  such  books."    The  language  of  some  of  the 
regulations  might  possibly  be  construed  to  mean  that  income 
was  to  be  returned  when  the  sale  was  made,  whether  for  cash 
or  credit,  but  the  forms  and  the  official  correspondence  prove 
that  the  most  fnaive  rform  of  cash  (income)  accounting  was 
contemplated.    Here,  again,  the  regulations  rest  not  so  much 
upon  a  judgment  in  individual  cases  as  to  whether  the  obliga- 
tion assumed  by  the  purchaser  is  the  equivalent  of  cash, 
but   upon   established    practice   among   agricultural    classes 
regarding  the  computation   of  the  thing  commonly  called 

income. 

Contracting  Companies.  In  this  business  costs  are  ordinarily 
kept  by  contracts  or  jobs  and  it  is  consequently  easy  to  com- 
pute profit  on  the  basis  and  at  the  time  of  collections  or  com- 
pleted  contracts.     The   actual   accounting   practice   among 

"  I  believe,  however,  that  the  reverse  would  not  hold  true, ».  e.,  that  a  taxpayer  in  one 
of  the  classes  required  by  these  articles  to  report  the  profit  at  the  time  the  sale  was  made 
would  not  be  so  required  in  case  he  could  demonstrate  that  the  obligation  had  no  fair 
market  value  or  was  not  actually  equivalent  to  cash. 

"C/.  T.  D.  2153- 


WHEN     IS     INCOME     REALIZED 


39 


contractors  differs.  Accordingly,  the  Treasury  has  from 
the  beginning"  accepted  from  such  taxpayers  an  extreme 
form  of  cash  accounting,  although  an  elastic  form  of  an  accrual 
accounting  has  also  been  recognized.  The  form  of  cash 
accounting  authorized  is  interesting  and  peculiar.  Apparently 
the  taxpayer  is  permitted  to  wait  until  payment  for  the  work 
is  actually  received,  but  then  it  must  be  "returned  as  income 
for  the  year  in  which  the  work  was  completed.  If  the  gross 
income  is  arrived  at  by  this  method,  the  deduction  from  gross 
mcome  should  be  limited  to  the  expenditures  made  on  account 
of  such  completed  contracts."  »*  This  illustrates  the  device 
of  an  "account  with  the  taxpayer,"  utilized  with  good  results 
in  Great  Britain. 

Isolated  Sales  of  Capital  Assets— Are  Claims  So 
Created  Income  When  Received? 

The  preceding  examination  of  the  method  of  computing 
mcome  reveals  an  evident  effort  to  follow  trade  practice,  with 
the  result  that  a  particular  method  has  been  prescrib^  or 
required  when  what  may  be  called  a  prevalent  practice  has 
been  discerned  in  a  given  trade  or  business,  while  an  option 
has  been  given  to  any  trade  or  business  in  which  the  practice 
IS  fundamentally  diverse.    It  will  be  noted,  however,  that  these 
rules  apply  in  general  to  dealers  or  to  individuals  regulariy 
receiving  the  kind  of  income  in  question.    They  apply  particu- 
larly to  mass  transactions— to  a  volume  of  sales  or  to  recurring 
receipts  of  the  same  kind.    Moreover,  the  fact  that  the  tax- 
payer  is  dealing  with  a  volume  or  mass  of  transactions  is 
important.    There  is  safety  in  numbers.    It  is  reasonable,  for 
instance,  to  require  a  taxpayer  to  treat  the  entire  body  of  his 
book  accounts  for  a  taxable  year  as  a  substantial  equivalent 
01  cash,    where  it  might  not  be  reasonable  to  require  him  to 

J^T.  D.  2161;    February  19.  1915. 

»^  no^"«'lrcour.i'lt'  ^^r-"^"^^  '«  ^^'"P"'^  "hi«  income  upon  the  basis  of  valuing 
oiea  or  accounu  receivable  at  their  fair  market  value  when  received."    Art.  151. 


ffiil 


I  w 


40         COLUMBIA     INCOME     TAX     LECTURES 

treat  a  particular  account  as  the  equivalent  of  cash.  If  the 
taxpayer  regularly  by  choice  sells  on  open  account,  it  is 
obvious  that  he  regards  the  average  book  account  at  least 
as  the  equivalent  of  cash.  Where  in  case  of  instalment  sales 
the  average  book  account  is  not  the  equivalent  of  cash  a 
method  of  cash  accounting  is  accepted. 

We  come  now  to  consider  isolated  or  casual  sales,  for  the 
treatment  of  which  there  is,  so  far  as  the  writer  knows,  no 
established  trade  practice  and  in  respect  of  which  the  particu- 
lar taxpayer  cannot  well  be  offered  an  option  on  the  condition 
that  he  deals  with  such  transactions  consistently  from  year 
to  year,  since  the  isolated  character  of  the  transaction  affords 
no  opportunity  for  consistent  treatment. 

The  practice  of  the  Treasury  in  connection  with  the  sale  of 
capital  assets  has  apparently  been  consistent  and  unvarying 
from  the  adoption  of  the  Act  of  August  5,  1909,  to  the  present 
time.  Regulations  No.  31,  issued  December  3,  1909,  provided 
that  the  taxable  gain  from  such  sales  should  be  "added  to  the 
gross  income  for  the  year  in  which  the  sale  was  made,"  and 
that  direction  has  been  repeated  in  all  the  regulations  issued 
from  that  time  to  the  present  date.'^  The  latest  regulations 
are  in  terms  confined  to  corporations  and  in  the  earlier  regu- 
lations much  stress  was  laid  upon  the  treatment  of  such  gains 
on  the  taxpayer's  books  of  account.  Thus  in  a  much  quoted 
Treasury  letter  to  Carey,  Piper  and  Hall,  dated  March  2, 
1915,  it  was  stated  that: 

Accounts  and  bills  receivable  of  a  corporation  are  to  be  treated  as 
income  for  the  year  in  which  they  are  created,  that  is  to  say,  in  the 
year  in  which  the  accounts  are  set  up  on  the  books  or  the  bills  receiva- 
ble are  accepted. 

However,  I  believe  that  the  rule  has  been  the  same  for 
all  taxpayers;  that  in  all  cases  a  presumption  existed 
that  the  gain  was  returnable  and  taxable  for  the  year  in 
which  the  sale  was  made,  but  that  this  presumption 
could  be  defeated  by  proof  that  the  claim  or  the  obliga- 
tion assumed  by  the  purchaser  was  not  in  fact  the  equivalent 
of  cash. 

»  Art.  545. 


WHEN     IS     INCOME     REALIZED 


41 


Compensation   for  Personal  Service,    Interest,  Rents 

AND  Dividends*^ 

The  specific  question  here  under  discussion  is  whether 
wages,  salaries,  rent  or  interest  due  in  one  taxable  year,  but 
paid  in  another,  are  income  for  the  year  in  which  due.  On 
this  precise  point  the  more  formal  regulations  and  Treasury 
decisions  have  been  somewhat  evasive,  but  in  repeated  letters 
to  taxpayers  which  have  been  given  wide  circulation  and  in 
its  more  informal  rulings  the  Treasury  has  made  it  clear  that 
the  taxpayer  was  expected  to  report  such  income  not  when 
due,  but  when  actually  or  constructively  received  by  him.^' 
The  language  of  some  of  these  rulings  even  suggest  that  tax- 
payers keeping  books  on  an  accrual  basis,  with  respect  to 
income  accrued  before  January  i,  1918,  would  be  permitted 
to  return  such  items  on  the  cash  basis.^^ 

The  Treasury  has  approached  very  close  to  the  doctrine 
that  collectible  claims  for  due  but  unpaid  wages,  salaries, 
interest  and  rent  become  income  when  created.  Payments 
of  this  class  when  made  in  liberty  bonds,  corporate  stock,  or 
promissory  notes  (received  in  payment  and  not  merely  as 
security  for  payment);  dividends  and  interest  paid  in  scrip; 
living  quarters  furnished  in  addition  to  salary,  and  not  "for 
the  convenience  of  the  employer,"  have  been  held  to  be  income 
for  the  year  in  which  received  or  furnished-^**  A  doctrine  of 
constructive  receipt  has  been  developed  under  which  inter- 
est coupons  which  have  matured,  dividends  which  have  been 
set  apart  for  the  stockholder,  interest  which  has  been  credited 
on  savings  bank  deposits,  amounts  which  have  been  credited 
without  restriction  to  the  shareholders  of  building  and  loan 
associations,  but  not  actually  collected,  are  income  for  the 
year  in  which  so  credited  or  made  available.^!    This  doctrine 

"  The  special  provisions  for  taxing  certain  dividends  at  the  rates  prescribed  for  the 
years  in  which  the  profiu  or  surplus  were  accumulated  are  not  here  reviewed. 

"C/.  I.  T.  S.  1919,  ^1  887,  920.  921.  922,  923. 

>•  Income  Tax  Primer,  as  Revised  March  i.  1919,  ss.  23.  24. 

»•  With  respect  to  dividends  it  has  been  held  (I.  T.  R.  140)  that  "the  date  of  payment 
rather  than  the  date  of  receipt  is  the  governing  factor  in  determining  when  a  dividend 
•hould  be  treated  as  taxable  income  to  the  recipient." 

"  Arts.  S3,  54. 


1  \ 


\ 


42         COLUMBIA     INCOME     TAX     LECTURES 

has  been  applied  to  compensation  for  personal  service.** 
But  except  in  a  few  isolated  cases,"^  obviously  contrary  to 
.  the  great  majority  of  rulings,  the  Treasury  has  not  treated 
wages,  salaries,  rent  or  interest  due  but  unpaid  as  income, 
even  though  the  claim  or  obligation  were  unquestionably  the 
equivalent  of  cash. 

The  difference  in  the  Treasury  attitude  towards  such 
income  and  gains  or  profits  derived  from  the  sale  of  property 
is  partly  ascribable  to  court  decisions  reviewed  hereafter, 
but  in  the  main  is  due,  I  believe,  to  the  probable  fact  that  a 
majority  of  the  persons  who  receive  wages,  salaries,  fees, 
rent,  interest  and  dividends  treat  them  as  income  only  when 
actual  payment  is  made.  Many  corporations  and  business 
concerns  take  them  up  on  their  books  when  due  or  even  as 
they  are  earned,  it  is  true,  but  the  prevailing  practice — if  any 
can  be  said  to  exist — probably  inclines  to  the  cash  basis; 
and  this  was  even  more  true  in  the  past  than  at  present. 
However,  it  is  past  practice  rather  than  present  practice 
which  fixes  the  connotations  of  words,  particularly  in  the 
legal  interpretation.  Nor  is  there  the  same  logical  or  practical 
necessity  to  treat  wages,  interest  and  the  like  as  income  when 
due.  In  computing  the  net  income  derived  from  these  items, 
inventories  do  not  figure  at  all,  and  the  deductions  for  cost 
and  expense  are  comparatively  unimportant,  frequently 
absent  altogether.  When  property  is  parted  with  in  exchange, 
intelligent  bookkeeping  makes  it  practically  necessary  to  set 
up  on  the  books  a  corresponding  asset  and  it  can  hardly  be  set 
up  without  being  constructively  regarded  as  "received."  But 
when  personal  service  is  sold  for  wages  or  a  fee,  or  when  the 
use  of  capital  is  parted  with  for  interest,  no  "asset  goes  out" 
in  like  sense,  to  balance  which  an  incoming  asset  must  be  rec- 
ognized. In  short  the  logic  and  the  practice  are  not  the  same 
as  in  the  case  of  income  derived  from  sales  of  property. 

Rationale  of  the  Treasury  Regulations 
Suiveying  all  the  Treasury  regulations  which  have  here 
been  reviewed,  from  those  relating  to  merchants'  sales  to  those 

«  I.  T.  S.  1919.  If  858. 

"  C/.  ruling  discussed  in  Edwards  v.  Keith,  231  Fed.  no. 


WHEN     IS     INCOME     REALIZED 


43 


affecting  wages  and  interest,  it  will  be  seen  that  they  create  a 
set  of  initial  presumptions  which  in  turn  rest  upon  practice, 
logic  and  administrative  necessity.  Merchants  and  manu- 
facturers are  presumed  to  compute  net  income  on  the  basis  of 
all  sales,  but  are  permitted  to  value  or  appraise  the  correspond- 
ing accounts  or  bills  receivable  when  created  or  to  write  them 
off  when  ascertained  to  be  worthless.  Instalment  dealers  and 
farmers  and  those  who  sell  real  estate  on  small  initial  payment, 
along  with  those  who  receive  salaries,  wages,  fees,  rents  and 
dividends,  have  been  presumed  to  report  on  a  cash  basis  but 
are  permitted,  if  they  follow  the  practice  consistently,  to 
report  on  an  accrual  basis.  Sales  of  capital  assets,  when  a 
substantial  part  of  the  consideration  is  paid  in  cash,  are  pre- 
sumed to  create  income  when  the  sale  is  consummated;  but 
even  here  the  vendor  may,  I  believe,  avoid  the  presumption 
by  proving  that  the  consideration  is  not  or  was  not  in  fact  the 
equivalent  of  cash.  The  test  or  principle  of  cash  equivalence 
has  been  applied  mercifully  if  not  rigidly  or  consistently. 
Where  the  initial  presumption  treats  the  credit  or  claim  as 
income,  the  taxpayer  has  been  permitted  to  disregard  the 
presumption  by  proving  that  the  claim  is  not  the  equivalent 
of  cash.  Where  the  presumption  was  the  other  way,  the  tax- 
payer who  kept  books  on  the  accrual  basis  was  permitted  to 
follow  his  books."  In  these  cases,  however,  in  which  the  cash 
basis  was  presumed,  the  Treasury  did  not  reserve  nor  exercise 
the  right  to  defeat  the  presumption  that  the  claim  was  not  the 
equivalent  of  cash,  by  proving  the  contrary. 

These  presumptions  follow  as  closely  as  practicable,  I 
believe,  the  prevailing  practice  among  the  classes  concerned, 
in  so  far  as  it  is  possible  to  see  that  any  particular  practice 
"prevails."  Taxpaying  and  tax-gathering  constitute  an 
eminently  practical  trade  which  must  be  conducted  on  a 
wholesale  scale.  Rules  applicable  to  millions  of  taxpayers, 
to  be  enforced  by  thousands  of  governmental  employees,  not 
always  expert  or  thoroughly  trained,  must  adhere  in  the  main 
to  prevailing  practice.  There  is  no  real  choice  to  do  otherwise. 
The  Sixteenth  Amendment  did  not,  I  take  it,  authorize  the 

**  He  was  not  required  to  follow  them  until  the  Revenue  Act  of  1918  took  effect. 


fi'  i 


44         COLUMBIA     INCOME     TAX     LECTURES 

taxation  (without  apportionment)  of  some  mystical  quan- 
tum—"income"— which  never  was  on  land  or  sea.  It  author- 
ized the  levy  and  collection  of  a  workable  tax  of  so  much 
practicable  importance  that  it  is  only  a  slight  exaggeration  to 
say  that  without  its  use  in  some  form  no  modern  nation  can 
wage  or  win  a  major  war.  Rules  and  regulations  which  do 
not  follow  practice— indeed  which  do  not  adapt  themselves 
elastically  to  the  variations  of  practice— will  simply  be  dis- 
regarded in  the  great  mass  of  cases.  All  this  is  too  often 
forgotten  by  taxpayers,  economists,  administrative  officials 
and  the  courts.  After  all,  when  everything  has  been  said  and 
the  resources  of  legal  procedure,  accounting  logic,  and  economic 
principle  have  been  exhausted,  the  great— perhaps  the  con- 
trolling—fact remains  that  a  great  tax  is  to  be  collected  from 
millions  of  taxpayers,  and  the  only  way  that  this  can  be  suc- 
cessfully accomplished  is  by  adapting  its  terms  to  prevailing 
usage  among  the  taxpayers  affected. 

It  is  worthy  of  note  that  the  practice  or  custom  within 
particular  industries  or  callings  is  not  always  a  matter  of 
general    knowledge.     An   investigation   of   the   actual    facts 
frequently  surprises  people  who  have  a  very  wide  and  accurate 
knowledge  of  business  practice.     To  make  regulations  or  to 
decide  cases  by  processes  of  formal  verbal  logic  and  to  assume 
that  the  meaning  of  the  words  "income  received"  is  plain  to  all 
men,  is  either  to  lay  down  rules  which  will  be  almost  universally 
flouted  by  taxpayers,  or  to  throw  the  administration  of  the 
tax  into  such  confusion  as  to  endanger  its  continued  use. 
"Income  received  means  income  received— that  is  all  there  is 
to  it,"  is  apparently  a  simple  way  out  of  the  dilemma.    In  my 
opinion  it  is  neither  a  simple  nor  a  practicable  way  out.    There 
is  a  truer  simplicity  in  the  effort  to  follow  the  practices  of 
different  classes  of  taxpayers  in  computing  the  thing  which 
they  report  to  their  banks  and  creditors  and  their  stockholders 
as  net  income;  and  the  effort  of  the  Treasury— groping  and 
mistaken  at  times  without  doubt— to  follow  the  winding  paths 
of  practice  and  usage  is,  I  believe,  as  wise  as  it  is  in  the  long 
run  unavoidable.     The  Treasury  is  not  free  to  make  such 
regulations  as  to  it  seem  wise  and  fit;  it  is  controlled  not  only 


WHEN     IS     INCOME     REALIZED 


45 


by  the  statute  and  the  courts  but  it  is  dominated  by  inexorable 
administrative  necessities. 

Court  Decisions 

The  regulations  of  the  Treasury  have  been  examined  at 
some  length  in  order  to  emphasize  the  foundations  upon  which 
they  rest — commercial  practice,  common  usage  and  adminis- 
trative necessity.  No  exhaustive  review  of  the  court  decisions 
is  possible  at  this  place.  They  have  been  collected  and  may 
be  conveniently  examined  in  the  current  manuals.^ 

These  decisions  appear  to  determine  definitely  the  law  on 
this  subject  as  it  relates  to  compensation  for  personal  service, 
fees,  commissions,  insurance  premiums,  interest  and  dividends. 
They  rest  for  the  most  part  upon  the  "natural  and  obvious" 
or  the  "ordinary  and  popular"  meaning  of  the  words  "income 
received"  or  "income  derived."  The  following  citation  from 
a  decision  of  the  Court  of  Claims  of  the  United  States  approved 
(rather  silently  so  far  as  this  particular  point  is  concerned)  by 
the  Supreme  Court  of  the  United  States  is  perhaps  typical: 

The  word  "income"  as  used  in  revenue  legislation,  has  a  settled 
legal  meaning.  The  courts  have  uniformly  construed  it  to  include 
only  the  receipt  of  actual  cash  as  opposed  to  contemplated  revenue  due 
but  unpaid,  unless  a  contrary  purpose  is  manifest  from  the  language 
of  the  statute.  What  is  taxed  by  the  terms  of  the  foregoing  statutes 
is  "net  income  received,"  not  income  accruing  or  accrued  which  has  not 
been  received  and  portions  of  which  may  never  be  received.  While 
the  phrases  "income  received"  and  "income  accrued"  are  frequently 
used  in  the  same  statute,  the  courts  have  not  departed,  unless  it 
expressly  appears  otherwise,  from  a  construction  of  the  law  in  accord 
with  an  intention  to  reach  the  actual  and  not  the  potential  income 
of  the  corporation.  In  the  income-taxing  act  of  1913  (38  Stat.  L.,  172) 
the  t>yo  preceding  phrases  are  employed;  in  fact,  the  act  of  19 13,  in 
speaking  of  incomes  as  applied  to  insurance  companies  and  domestic 
corporations,  uses  the  above  phrases  as  follows:  "Income  arising  or 
accruing,"  "income  received,"  and  "income  accrued."  Doubtless  it 
was  the  intention  of  Congress  in  legislation  of  this  character  to  employ 
terms  of  sufficient  comprehension  to  reach  the  actual  income  of  the 
corporation  by  foreclosing  any  possible  avenue  of  escape,  but  it  can 
hardly  be  said  that  in  so  doing  an  intention  prevailed  to  tax  that  which 
did  not  actually  exist,  except  on  paper,  as  income  accrued  during  the 

»  Particularly  Holmes.  Federal  Taxes,  chap.  14.    Cf.  also  Notes  on  the  Revenue  Act  of 
iqjS,  eU. 


i  I- 

•  i'l, 


;  f 


46    COLUMBIA  INCOME  TAX  LECTURES 

taxing  period.  One  can  not  be  said  to  receive  an  income  of  defined 
proportions  until  he  balances  receipts  and  deductions  at  the  end  of  a 
stated  period  and  ascertains  not  what  is  due  but  what  has  been  actually 
received.  The  assets  and  liabilities  of  a  corporation  may  be  measured 
by  a  different  rule  of  accounting,  but  income  as  defined  by  the  courts 
means,  as  said  in  United  States  v.  Schillinger  (14  Blatchf.,  71),  "in 
the  absence  of  any  special  law  to  the  contrary,  income  must  be  taken 
to  mean  money,  and  not  the  expectation  of  receiving  it  or  the  right 
to  receive  it  at  a  future  time."  * 

In  the  Schillinger  case  referred  to  above  it  was  held  that 
"where  the  effect  of  transaction  is  a  mere  promise  to  pay  and 
not  an  actual  payment  it  cannot  be  said  to  be  income  until  it 
has  been  actually  received  and  is  not  subject  to  be  taxed  as 
such  until  it  is  actually  received."  "  in  this  case  certain  patent 
rights  were  exchanged  or  "changed"  for  promissory  notes 
which  were  duly  paid,  although  the  Court  said  "their  value 
was  uncertain;  they  might  or  might  not  be  paid;  but  until 
they  were  paid,  they  were  not  income,  but  only  the  ground  of 
expecting  income." 

These  decisions  raise  an  exceedingly  seiious  question.  Prob- 
ably sixty  per  cent,  of  the  income  taxes  which  have  been 
collected  since  1909  have  been  based  upon  sales  as  made  and 
not  upon  receipts  as  collected.  Must  we  therefore  conclude 
that  the  regulations  as  they  related  to  merchants  and  manu- 
facturers have  been  wrong,  that  the  tax  in  all  these  cases  has 
been  incorrectly  computed,  and  that  the  assessments  are 
invalid? 

Grounds  for  the  belief  that  these  conclusions  do  not  neces- 
sarily apply  to  profits  derived  from  the  sale  of  property, 
particulariy  stock-in-trade  of  merchants  and  manufacturers, 
may  be  found  in  the  case  of  Hays  v.  Gauley  Mountain  Coal 
Company,^^  and  Doyle  v.  Mitchell  Bros.  Company}^  In  the 
former  case  the  Court,  doubtless  using  the  words  in  "their 
natural  and  obvious  sense"  or  in  the  "ordinary  and  popular 
acceptation,"  speaks  repeatedly  of  appreciation  in  the  value  of 
property  before  sale  as  "accrued  income."  For  example  the 
Court  said:    "The  expression  'income  received  during  such 

»  Maryland  Casualty  Co.  v.  U.  S.  52  Ct.  Cls.  201;  T.  D.  2451. 
"  Cf.  supra. 
"  247  U.  S.  189. 
**  247  U.  S.  179. 


WHEN     IS     INCOME     REALIZED 


47 


year',  employed  in  the  act  of  1909,  looks  to  the  time  of  realiza- 
tion rather  than  the  period  of  accruement,  except  as  the 
taking  effect  of  the  Act  on  a  specified  date  (January  i,  1909) 
excludes  income  that  accrued  before  that  date."  As  evidence 
of  the  "natural  and  obvious  sense"  of  words,  the  repeated  use 
of  the  term  "accrued  income"  in  this  decision  throws  doubt 
upon  extreme  statements  which  have  been  made  by  some  of 
the  lower  courts  to  the  effect  that  there  can  be  no  such  thing 
as  income  until  actual  payment  has  been  made  in  money  or 
something  other  than  a  mere  promise  to  pay.  Moreover,  if 
it  were  necessary,  a  strong  argument  could  be  made  for  the 
contention  that,  to  justify  all  of  the  conclusions  reached  by 
the  Supreme  Court  in  these  and  related  cases,  it  is  essential 
to  hold  that  income  or  profit  may  arise  or  accrue  before  sale. 
However,  involved  reasoning  would  be  out  of  place  in  dealing 
with  a  question  which  turns  largely  on  the  meaning  of  words, 
particularly  in  view  of  the  peculiar  finding  in  the  case  of 
Lynch  v.  Turrish^^  which  makes  it  doubtful  whether  appre- 
ciation in  the  value  of  capital  assets  is  income  at  all.  Yet 
even  in  that  case  the  Court  held:  "If  increase  in  the  value 
of  the  lands  was  income  it  had  its  particular  time,  and 
such  time  must  have  been  within  the  time  of  the  law  to  be 
subject  to  the  law,  that  is,  it  must  have  been  after  March  i, 
1913. 

In  short,  there  may  be  income  even  before  sale.  A  fortiori, 
there  may  be  income  before  final  payment  in  cash.  If,  then, 
mere  appreciation  in  value  is  accrued  income,  what  sort  of 
income  arises  when  sale  is  made,  and  title  to  the  property 
passes  to  the  purchaser,  even  though  he  has  paid  only  with  a 
note  or  a  mere  promise;  is  this  intermediate  form  of  income 
"received"  or  merely  "accrued"  in  another  sense?  It  is  my 
task  to  show,  if  possible,  that,  in  the  case  of  dealings  in  prop- 
erty, particularly  mass  dealings  or  sales  for  an  entire  year,  it 
may  be  held  to  be  received  or  realized  income. 

I  find  the  most  support  for  that  belief  in  the  case  of  Doyle  v. 
Mitchell  Bros.  Company. ^^    The  circumstances  of  that  case  are 

••  247  U.  S.  221. 

•«  Cf.  supra,  p.  46. 


48         COLUMBIA     INCOME     TAX     LECTURES 

familiar  and  I  shall  not  dwell  upon  them  except  to  emphasize 
the  fact  that  it  was  a  lumber  manufacturing  corporation, 
whose  stumpage  or  timber  had  appreciated  in  value  between 
the  purchase  date  in  1903  and  December  31,  1908;  and  that 
the  question  involved  was  whether  in  computing  taxable 
profit  on  sale  there  should  be  deducted  the  cost  of  the  stumpage 
in  1903  or  its  value  on  December  31,  1908.  It  was  held  in  this 
case: 

Yet  it  is  plain,  we  think,  that  by  the  true  intent  and  meaning  of  the 
act  the  entire  proceeds  of  a  mere  conversion  of  capital  assets  were  not 
to  be  treated  as  income.  Whatever  difficulty  there  may  be  about  a 
precise  and  scientific  definition  of  "income,"  it  imports,  as  used  here, 
something  entirely  distinct  from  principal  or  capital  either  as  a  sub- 
ject of  taxation  or  as  a  measure  of  the  tax;  conveying  rather  the  idea 
of  gain  or  increase  arising  from  corporate  activities.  As  was  said  in 
StrattorCs  Independence  v.  Howhert  (231  U.  S.  399,  415);  "Income  may 
be  defined  as  the  gain  deri\'ed  from  capital,  from  labor,  or  from  both 
combined." 

Understanding  the  term  in  this  natural  and  obvious  sense,  it  can 
not  be  said  that  a  conversion  of  capital  assets  invariably  produces 
income.  If  sold  at  less  than  cost,  it  produces  rather  loss  or  outgo 
Nevertheless,  in  many  if  not  in  most  cases  there  results  a  gain  that 
properly  may  be  accounted  as  a  part  of  the  "gross  income"  received 
"from  all  sources,"  and  by  applying  to  this  the  authorized  deductions 
we  arrive  at  "net  income."  In  order  to  determine  whether  there  has 
been  gain  or  loss,  and  the  amount  of  the  gain,  if  any,  we  must  withdraw 
from  the  gross  proceeds  an  amount  sufficient  to  restore  the  capital 
value  that  existed  at  the  commencement  of  the  period  unde  con- 
sideration. 

This  has  been  recognized  from  the  beginning  by  the  administrative 
officers  of  the  Government.  Shortly  after  the  passage  of  the  act,  and 
before  the  time  (March  i,  1910)  for  making  the  first  returns  of  income, 
the  Commissioner  of  Internal  Revenue,  with  the  approval  of  the 
Secretary  of  the  Treasury,  promulgated  Regulations  No.  31,  under 
date  December  3,  1909,  for  the  guidance  of  collectors  and  other  sub- 
ordinate officers  in  the  performance  of  their  duties  under  the  act. 
These  prescribed,  with  respect  to  manufacturing  companies,  that 
gross  income  should  consist  of  the  difference  between  the  price  re- 
ceived for  the  goods  as  sold  and  the  cost  of  such  goods  as  manufactured; 
cost  to  be  "ascertained  by  an  addition  of  a  charge  to  the  account  of 
the  cost  of  goods  as  manufactured  during  the  year  of  the  sum  of  the 
inventory  at  beginning  of  the  year  and  a  credit  to  the  account  of  the 
sum  of  the  inventory  at  the  end  of  the  year."  In  the  case  of  mer- 
cantile companies,  gross  income  was  to  be  the  "amount  ascertained 
through  inventory,  or  its  equivalent,  which  shows  the  difference  be- 
tween the  price  received  for  goods  sold  and  the  cost  of  goods  pur- 
chased during  the  year,  with  an  addition  of  a  charge  to  the  account  of 


WHEN     IS     INCOME     REALIZED 


49 


the  sum  of  the  inventory  at  beginning  of  the  year  and  a  credit  to  the 
account  of  the  sum  of  the  inventory  at  the  end  of  the  year."  And  as 
to  miscellaneous  corporations,  gross  income  was  to  be  "the  gross 
revenue  derived  from  the  operation  and  management  of  the  business 
and  property  of  the  corix)ration,"  with  all  income  derived  from  other 
sources.  The  matter  of  income  arising  from  a  profitable  sale  of  capital 
assets  was  dealt  with  specifically  in  such  a  way  as  to  limit  the  tax  to 
income  arising  after  the  effective  date  of  the  act.  This  was  done  by 
adopting  the  rule  that  an  advance  in  value  arising  during  a  period 
of  years  should  be  so  adjusted  that  only  so  much  as  properly  was 
attributable  to  the  time  subsequent  to  January  i,  1909  (December  31, 
1908,  would  have  been  more  precise),  should  be  subjected  to  the  tax. 

At  this  point  the  Court  quoted  that  paragraph  from  Treasury 
Regulations  No.  31,  issued  December  3,  1909,  which  deals  with 
"Sale  of  Capital  Assets." 

Now  these  regulations,  quoted  with  approval  by  the  Court, 
have  been  in  substance  maintained  by  the  Treasury  from  that 
time  to  this.  The  Court  apparently  recognizes  the  necessity 
of  employing  inventories.  The  use  of  inventories  necessarily 
involves  a  deduction  of  the  cost  of  goods  which  have  left  the 
establishment,  i.e.,  which  have  been  sold.  Surely  the  Court 
did  not  contemplate  that  the  cost  of  all  goods  sold  should  be 
deducted  without  including  the  selling  prices  of  all  goods  sold 
whether  paid  for  in  money  or  not.  I  stress  this  point  because 
the  language  of  the  regulations  in  question  on  first  reading  is 
ambiguous.  The  regulations  speak  of  "an  accounting  that 
shows  the  difference  between  the  price  received  ^^  for  the  goods 
sold  and  the  cost  of  such  goods  as  manufactured."  A  reading 
of  the  regulations  will  show  that  the  words  "price  received" 
do  not  mean  money  actually  received.  The  regulations 
quoted  by  the  Court  were  followed  almost  immediately  by 
this  statement: 

It  will  be  noted  from  these  definitions  that  gross  income  is  prac- 
tically the  same  as  gross  profits,  the  only  difference  being  that  gross 
income  is  more  inclusive,  embracing  as  it  does  not  only  gross  profits 
of  the  corporation,  joint-stock  company  and  association  itself,  but  also 
u  ^7*°""^^  ^^  income  received  from  other  sources.  It  is  immaterial 
whether  any  item  of  gross  income  is  evidenced  by  cash  receipts  during 
u  u^^^  ^^  *"  ^"^^  ®^^^^  manner  as  to  entitle  it  to  proper  entry  on 
the  books  of  the  corporation  from  January  i  to  December  31  for  the 
year  in  which  return  is  made. 

«*  Italics  are  the  writer't. 


:  / 


1 

!    1 


50         COLUMBIA     INCOME     TAX     LECTURES 

Similarly  the  regulations  relating  to  deductions  include  the 

following  statement: 

It  is  immaterial  whether  the  deductions  are  evidenced  by  actual 
disbursements  in  cash,  or  whether  evidenced  in  such  other  way  as  to 
be  properly  acknowledged  by  the  corporate  officers  and  so  entered  on 
the  books  as  to  constitute  a  liability  against  the  assets  of  the  corpora- 
tion, joint-stock  company,  association,  or  insurance  company  making 
the  return. 

Surveying  this  decision  in  its  entirety,  it  is  hardly  too  much 
to  say  that  it  recognizes  those  familiar  processes  customarily 
and  usually  employed  in  computing  the  profits  or  net  income 
of  manufacturing  companies.  I  think  that  it  justifies  the 
Treasury  in  not  disturbing  the  general  attitude  which  it 
has  in  the  past  taken  towards  commercial  profit.  The  whole 
question  is  a  technical  and  difficult  one.  It  would  be  unjusti- 
fiable in  view  of  this  decision  for  the  Treasury  to  break  faith 
with  hundreds  of  thousands  of  taxpayers,  call  upon  them  for 
a  new  and  different  accounting  and  compute  taxes  on  the  basis 
of  collections  rather  than  sales  in  the  case  of  business  con- 
cerns. Commercial  usage  is  so  plain  in  such  cases  that  it 
is  not  to  be  overcome  by  rulings  relating  to  interest,  dividends, 
commissions,  fees,  and  insurance  premiums.  Looking  to  this 
case  as  well  as  to  the  findings  in  Hays  v.  Gauley  Mountain  Coal 
Company,  Lynch  v.  Hornby, ^^  and  Lynch  v.  Turrish,  I  believe 
the  Treasury  is  justified  in  holding  that  the  entire  body 
of  accounts  and  bills  receivable  representing  goods  sold  on 
credit  during  a  year  may  be  said  upon  the  sale  and  acceptance 
of  the  corresponding  goods  to  have  become  capital  assets 
replacing  those  goods,  and  to  have  passed  through  the  door 
of  income  in  becoming  capital  assets. 

"  247  U.  S.  339- 


i. 


CONSTITUTIONAL  ASPECTS  OF  FEDERAL 

INCOME  TAXATION 

BY 

Thomas  Reed  Powell,  LL.B.,  Ph.D. 


It  seems  somewhat  the  fashion  to  begin  a  paper  by  exalting 
the  importance  of  the  subject  which  it  is  to  treat.  It  may  be 
thought  that  the  subject  will  appreciate  the  compliment  and 
in  some  mysterious  way  gratefully  bestow  on  the  paper  an 
importance  it  would  not  otherwise  enjoy.  Much  as  my  paper 
needs  all  such  help  that  it  can  get,  candor  compels  me  to 
belittle  its  subject  rather  than  to  flatter  it.  The  constitu- 
tional aspects  of  federal  income  taxation  are  relatively  unim- 
portant. Now  and  then  the  Supreme  Court  may  find  in  the 
Constitution  an  obstacle  to  some  particular  exercise  of  the 
federal  taxing  power;  but  these  occasions  will  be  few  in  com- 
parison with  those  in  which  taxes  obviously  objectionable 
on  practical  grounds  will  be  found  free  from  constitutional 
fault.  Among  foolish  propensities,  high  rank  must  be  given 
to  the  instinct  to  exalt  one's  aversions  by  assuming^  that  they 
are  shared  by  the  Constitution  of  the  United  States.  The 
pastime  is  worse  than  futile;  it  is  often  positively  harmful. 
It  leads  the  opponents  of  legislative  programs  to  indulge  in 
bad  constitutional  arguments  to  the  neglect  of  good  practical 
ones.  By  and  large  the  Constitution  marks  only  the  out- 
side limits  of  unwise  legislation.  It  leaves  to  our  Solons  a 
broad  and  fertile  field  for  folly.  Some  of  you  can  doubtless 
think  of  instances  where  this  license  has  been  availed  of. 
Some  of  you  may  discern  the  danger  of  more  indulgences  in 
the  near  future.  If  you  wish  to  restrict  these  to  the  minimum 
of  which  Congress  is  capable,  you  will  do  well  to  put  forth 
your  wisdom  in  its  naked  state,  without  troubling  to  tog  it 
out  in  constitutional  garb.  Have  recourse  to  the  Constitu- 
tion only  when  all  other  comforts  fail. 


1 1 


52         COLUMBIA     INCOME     TAX     LECTURES 


\  ' 


This  advice  has  special  application  to  objections  that  the 
federal  government  is  seeking  to  include  in  the  assessment  of  an 
income  tax  something  that  is  not  technically  income.  Our 
doctors  of  economics  are  not  yet  in  such  happy  accord  that 
with  singleness  of  voice  they  can  advise  the  Supreme  Court 
as  to  the  one  and  only  right  definition  of  economic  income. 
Their  mode  of  reasoning  sometimes  reminds  one  of  Professor 
Sumner's  wise  saying  that  you  can  get  out  of  a  major  premise 
all  that  you  put  into  it.  It  is  not  hard  to  concoct  an  a  priori 
concept  which  makes  a  perfect  chrysalis  for  a  contemplated 
conclusion.  No  such  concept  is  inexorably  true  under  all 
circumstances  or  for  all  purposes.  There  are  always  other 
available  concepts  for  those  who  wish  other  results.  More- 
over, courts  are  not  bound  to  accept  economic  concepts  how- 
ever perfectly  they  please  the  economists.^  Legal  income 
and  economic  income  are  not  invariably  identical.  For 
example,  gain  must  be  an  essential  element  in  economic 
income.  One  who  merely  gets  back  part  of  his  capital  in  a 
changed  form  can  hardly  be  said  to  have  received  economic 
income.  Yet  payments  of  cash  *  and  property '  by  a  corpora- 
tion to  a  stockholder  have  been  held  income  within  the  Six- 
teenth Amendment  though  they  made  him  no  richer  than  he 
was  before  the  Amendment  was  in  force.  Income  from  capi- 
tal which  is  an  impairment  of  capital  and  not  a  gain  there- 
from must  be  an  anomaly  to  the  economist.  It  is  not  an 
anomaly  in  law.  Reasons  of  practical  convenience  for  treat- 
ing the  corporation  and  the  stockholder  as  distinct  individ- 
ualities are  accepted  by  the  Supreme  Court  as  adequate  for 
a  concept  of  legal  income  which  violates  sound  principles  of 
economic  income.     The  Constitution  is  construed  to  permit 

» Compare  Mr.  Justice  Peckham  In  Nicx)l  v.  Amea  (1899)  173  U.  S.  509,  515-516:  "In 
deciding  upon  the  validity  of  a  tax  with  reference  to  these  requirements,  no  microscopic 
examination  as  to  the  purely  economic  or  theoretical  nature  of  the  tax  should  be  indulged 
in  for  the  purpose  of  placing  it  in  a  category  which  would  invalidate  the  tax.  .  .  Taxa- 
tion is  eminently  practical,  and  is  in  fact  brought  to  every  man's  door,  and  for  the  purpote 
of  deciding  upon  its  validity  a  tax  should  be  regarded  in  its  actual,  practical  results,  rather 
than  with  reference  to  those  theoretical  or  abstract  ideas  whose  correctness  is  the  subject 
of  dispute  and  contradiction  among  those  who  are  experts  in  the  science  of  political 
economy." 

'  Lynch  v.  Hornby  (1918)  247  U.  S.  339. 

»  Peabody  v.  Eisner  (19 18)  247  U.  S.  347. 


CONSTITUTIONAL     ASPECTS 


53 


the  taxation,  as  income  from  capital,  of  what  a  man  cannot 
spend  without  depleting  his  capital.  So  one  should  be  cau- 
tious in  substituting  contentions  based  on  the  Constitution 
for  contentions  based  on  common  sense. 


I 

A  still  broader  reason  for  the  relative  unimportance  of 
federal  income  taxation  is  that  the  federal  government  is  not 
confined  to  the  taxation  of  income.  True,  in  so  far  as  its  power 
depends  upon  the  Sixteenth  Amendment,  it  can  assess  only 
what  the  Supreme  Court  thinks  may  reasonably  be  regarded 
as  income,  or  possibly  only  what  the  Supreme  Court  thinks 
is  really  income.  But  without  the  aid  of  the  Sixteenth  Amend- 
ment, the  federal  government  has  extensive  fiscal  powers. 
This  was  made  clear  in  the  first  case  *  which  dealt  with  the 
Corporation  Excise  Tax  of  1909.  The  Sixteenth  Amendment » 
was  not  then  in  existence.  The  Pollock  Case »  was  still  the 
law  of  the  land.  Under  it  Congress  could  not  levy  an  unap- 
portioned  tax  on  income  from  state  or  municipal  bonds  or  on 
income  from  real  or  personal  property.  The  restriction  on 
taxing  income  from  state  and  municipal  bonds  was  predicated 
on  the  long-established  principle  that  neither  the  states  nor 
the  United  States  may  exercise  their  undoubted  powers  over 
the  undoubted  powers  of  the  other.»  Income  from  property 
was  sheltered  for  the  reason  that  a  tax  on  income  was  regarded 
as  in  substance  a  tax  on  the  source  of  the  income.  As  a  tax 
on  property  was  concededly  a  direct  tax,  a  tax  on  the  income 
therefrom  was  put  in  the  same  class.    But  a  tax  on  business 

« Hint  V.  stone  Tracy  Co.  (191 1)  220  U.  8.  107. 

•  The  Amendment  was  ratified  by  the  requisite  number  of  states  on  February  3    1913 
and  on  February  25.  1913.  Secretary  of  State  Knox  certified  that  it  had  become  a  part  of 
the  Constitution.    It  reads  as  follows:   "The  Congress  shall  have  power  to  lay  and  collect 
texes  on  incomes,  from  whatever  source  derived,  without  apportionment  among  the  several 
Mates,  and  without  regard  to  any  census  or  enumeration." 

•  Pollock  r.  Farmer*'  Loan  &  Trust  Co.  (189s)  IS7  U.  S.  429.  158  U.  S.  601. 
M'Culloch  r.  Maryland  (1819)  4  Wheat.  316;    Weston  v.  Charleston  (1829)  2  Pet. 

449;   Dobbins  V.  Erie  County  (1842)  16  Pet.  435;    Bank  of  Commerce  r.  New  York  City 
(1862)  2  Black  620;   Bank  Tax  Case  (1864)  2  Wall.  200;  CoUector  v.  Day  (1871)  n  WaU 
113:  United  States  v.  Railroad  Co.  (1873)  17  WaU.  322;  Van  Brocklin  v.  Tennessee  (1886) 
.    D    u    i^''  Home  Savings  Bankr.  Des  Moines  (1907)  205  U.  S.  503;  Bank  of  California 
».  Richardson  (1919)  248  U.  S.  476. 


ii 


r 


54         COLUMBIA     INCOME     TAX     LECTURES 

was  never  regarded  as  a  direct  tax.  Therefore  a  tax  on  the 
income  from  business  was  not  within  the  proscription  of  the 
Pollock  Case.  The  tax  on  income  from  business  fell  only 
because  it  was  thought  that  Congress  would  not  have  taxed 
such  income  unless  it  were  allowed  to  reach  other  income  as 
well.  The  inference  was  that  taxes  on  income  from  business 
would  be  sustained  as  indirect  taxes  whenever  they  were 
unmixed  with  other  taxes  thought  direct. 

In  reliance  on  this  inference  Congress  passed  the  Corpora- 
tion Excise  Tax  of  1909.  The  subject  selected  for  taxation 
was  not  income  but  carrying  on  business  as  a  corporation. 
The  measure  of  the  annual  demand  on  each  corporation  was 
its  net  income  as  computed  under  the  provisions  of  the  Act. 
In  Flint  v.  Stone  Tracy  Co.,^  decided  in  191 1,  a  unanimous 
Supreme  Court  held  the  tax  an  indirect  one  and  permitted 
the  assessment  to  include  not  only  income  directly  from 
business  but  also  income  from  municipal  bonds  and  from 
other  property  not  directly  or  actively  used  in  the  corporate 
business.  We  may  criticise  the  legerdermain  by  which  a  few 
words  in  a  statute  turn  a  tax  on  income  into  a  tax  on  something 
else  merely  measured  by  income;  but  we  must  believe  in  it 
as  the  gentleman  believed  in  baptism,  because  he  had  seen 
it  done.  Mr.  Justice  Day  assures  us  that  the  difference 
between  the  Income  Tax  of  1894  and  the  Corporation  Excise 
Tax  of  1909  "is  not  merely  nominal,  but  rests  upon  substan- 
tial differences  between  the  mere  ownership  of  property  and 
the  actual  doing  of  business  in  a  certain  way."'  The  tax 
directly  on  income  from  property  has  an  "element  of  absolute 
and  unavoidable  demand"  ^°  which  makes  it  a  tax  on  property 
merely  because  of  its  ownership.  In  taxes  on  privileges  the 
element  of  absolute  and  unavoidable  demand  is  lacking. 
"If  business  is  not  done  in  the  manner  prescribed  in  the 
statute,  no  tax  is  payable."  " 

•  (191 1)  220  U.S.  107. 

*  Ibid.,  150. 
i^Ihid.,  IS  I. 

"iWd.  Thomas  v.  United  States  said  of  a  tax  on  agreemenU  to  tell  stock:  "The 
stamp  duty  is  contingent  on  the  happening  of  the  event  of  sale,  and  the  element  of  absolute 
and  unavoidable  demand  is  lacking.  As  such  it  falls,  as  stamp  taxes  ordinarily  do.  withio 
the  second  class  of  the  forms  of  taxation."    This  second  class  is  that  of  indirect  taxes. 


CONSTITUTIONAL     ASPECTS 


55 


While  the  subject  of  the  Corporation  Excise  Tax  was  re- 
ferred to  by  the  Court  as  a  "privilege,"  it  was  in  no  sense  a 
privilege  granted  by  the  federal  government,  and  the  tax 
was  not  therefore  justified  as  a  sort  of  a  bonus.  Other  cases 
prior  to  the  Sixteenth  Amendment  make  clear  that  taxes  on 
acts  or  occupations  are  excise  taxes  which  may  be  levied  by 
the  United  States  without  any  apportionment  among  the 
states  according  to  population.  They  make  clear  also  that 
excises  on  acts  and  occupations  may  be  measured  in  other  ways 
than  by  net  income.  The  cases  that  have  sustained  as  indi- 
rect taxes  the  various  excises  on  particular  acts  and  particular 
occupations  show  that  an  excise  on  doing  business  in  general 
would  be  an  indirect  tax.  After  the  Pollock  Case  and  before 
the  Sixteenth  Amendment  a  suggestion  appeared  that  Con- 
gress impose  an  excise  on  doing  business  and  measure  its 
demand  by  the  total  income  of  each  person  subject  to  it, 
whether  that  income  came  directly  from  the  business  or  from 
property  unconnected  with  the  business.  Mr.  Justice  Day's 
opinion  in  the  Stone-Tracy  Case  indicates  that  the  Supreme 
Court  might  have  winked  at  such  a  subterfuge.  "The  posses- 
sion of  large  assets,"  he  says,  "is  a  business  advantage  of  great 
value." "  It  gives  standing  and  prestige,  helps  credit,  and 
facilitates  purchases.  To  him  that  hath  shall  be  given.  Such 
a  tax  would  not  have  hit  nonfeasant  widows  and  orphans  or 
any  of  the  really  ?dle  rich.  Doubtless  the  Court  would  have 
balked  at  recognizing  coupon-clipping  as  itself  a  business, 
so  there  would  have  been  some  income  that  such  a  tax  could 
not  reach.  This  particular  question  has  been  deprived  of 
practical  importance  by  the  Sixteenth  Amendment.  But 
the  power  of  Congress  apart  from  that  Amendment  deserves 
consideration  for  its  revelation  that  assessments  which  might 
be  defeated  when  laid  formally  on  income  may  be  victorious 
if  levied  in  special  acts  or  occupations  or  on  doing  business 
in  general.  The  presence  of  this  independent  power  shows 
the  weakness  of  reliance  on  the  Constitution  when  to  a  large 
extent  the  Constitution  forbids,  not  the  thing  done,  but  only 
the  particular  way  of  doing  it.     An  individual  litigant  may 

"  220  U.  S.  107.  166. 


( 


56 


COLUMBIA  INCOME  TAX  LECTURES 


I 


\  ' 


find  it  worth  his  while  to  escape  from  the  toils  of  a  statute 
even  though  it  may  readily  be  amended  so  that  he  is  firmly 
held  the  following  year.  But  such  Pyrrhic  victories  are  not 
very  valuable  to  those  who  are  thinking  of  what  government 
may  or  may  not  do  in  the  long  run. 

We  turn,  then,  to  the  excise  taxes  which  the  federal  govern- 
ment may  levy  without  the  aid  of  the  Sixteenth  Amendment. 
In  1869  Mr.  Justice  Swayne  approved  a  definition  of  an  excise 
which  called  it  "an  inland  imposition,  sometimes  upon  the 
consumption  of  a  commodity,  and  sometimes  on  the  retail 
sale;  sometimes  upon  the  manufacturer,  and  sometimes  upon 
the  vendor."  ^^  Between  the  Pollock  Case  and  the  Sixteenth 
Amendment,  federal  levies  on  the  refining  of  sugar,^*  on  the 
manufacture  of  colored  oleomargarine^^  and  of  filled  cheese,^* 
on  holding  tobacco  for  sale,^^  on  sales  at  exchanges,**  on  con- 
tracts to  sell  stock,^^  on  the  transmission  of  property  by  inheri- 
tance,2°  and  on  doing  business  as  a  corporation  ^i  were  held  to 
be  excises.  Before  the  Pollock  Case,  taxes  on  the  insurance 
business,22  on  the  issue  of  notes  by  a  bank,^  and  on  being 
prepared  to  distill  spirits,^^  were  held  excises,  and  these  de- 
cisions are  unshaken  by  anything  said  or  done  since.  Taxes 
on  commercial  instruments  have  been  levied  without  number 
and  never  been  questioned  as  not  indirect  taxes.^  After  the 
Sixteenth  Amendment  a  tax  on  the  use  of  foreign-built  yachts 
by  an  American  citizen  was  sustained  as  an  excise.^*    These 

i»  Pacific  Insurance  Co.  v.  Soule  (1869)  7  Wall.  433.  445- 

"  Spreckels  Sugar  Refining  Co.  v.  McClain  (1904)  192  U.  S.  397. 

"  McCray  v.  United  States  (1904)  I9S  U.  S.  27. 

"  Cornell  v.  Coyne  (1904)  192  U.  S.  418. 

»'  Patten  V.  Brady  (1902)  184  U.  S.  608. 

"  Nicol  V.  Ames  (1899)  I73  U.  S.  509. 

"  Thomas  v.  United  States  (1904)  192  U.  S.  363.  This  case  refers  to  Treat  v.  White 
(1901)  181  U.  S.  264,  holding  that  a  "call"  for  stock  is  an  agreement  to  sell  within  the  statute 
taxing  such  agreements. 

»«  Knowlton  v.  Moore  (1900)  178  U.  S.  41- 

"  Flint  V.  Stone  Tracy  Co.  (191 1)  220  U.  S.  107. 

a  Pacific  Insurance  Co.  r.  Soule  (1869)  7  Wall.  433- 

"  Veazie  Bank  v.  Fenno  (1869)  8  Wall.  533- 

"United  States  r.  Singer  (1872)  is  Wall.  iii. 

»  For  instances  in  which  stamp  taxes  on  commercial  instruments  have  been  held  taxes 
on  exports,  see  Fairbank  v.  United  States  (1901)  181  U.  S.  283;  United  States  v.  Hvoslef 
(191S)  237  U.  S.  i;  Thames  &  Mersey  M.  Ins.  Co.  v.  United  States  (1915)  237  U.  S.  19- 

»  BUUngs  V.  United  States  (1914)  232  U.  S.  261;  United  States  v.  Bennett  (1914)  23* 
U.  S.  299. 


CONSTITUTIONAL     ASPECTS 


57 


decisions  carry  us  beyond  the  definition  given  by  Mr.  Justice 
Swayne  in  1869.  Excise  taxes  are  not  limited  to  those  on  the 
manufacture  or  sale  of  commodities.  They  include  impositions 
on  other  acts  and  transfers.  In  191 1  Mr.  Justice  Day  quoted 
with  approval  Chief  Justice  Fuller's  earlier  statement  that  the 
words  "duties,"  "imposts,"  and  "excises"  are  used  in  the  Con- 
stitution "comprehensively  to  cover  customs  and  excise  duties 
impKDsed  on  imp>ortation,  consumption,  manufacture,  and  sale 
of  certain  commodities,  privileges,  particular  business  transac- 
tions, occupations,  and  the  like.'*^^ 

Up  to  this  time  the  Supreme  Court  appears  to  have  thought 
that  no  duty,  impost,  or  excise  could  be  a  direct  tax.  For  in 
this  same  opinion  of  1911  Mr.  Justice  Day  observes:  "If  we 
are  correct  in  holding  that  this  is  an  excise  tax,  there  is  nothing 
in  the  Constitution  requiring  such  taxes  to  be  apportioned 
according  to  population."  ^*  But  after  the  Sixteenth  Amend- 
ment the  analysis  was  revamped  a  bit.  In  finding  out  what 
the  Sixteenth  Amendment  meant  to  accomplish  from  the 
words  "from  whatever  source  derived,"  it  was  discovered  that 
an  income  tax  was  always  generically  an  indirect  tax  but  that 
it  sloughed  off  its  generic  character  and  became  in  substance  a 
direct  tax  whenever  it  laid  hold  of  income  from  property 
merely  because  of  its  ownership.^®  This  is  to  say  that  an 
excise,  though  in  form  an  indirect  tax,  may  be  in  reality  a 
direct  tax  whenever  it  is  in  substance  a  tax  on  property  because 
of  its  ownership.  This,  however,  is  qualified  by  the  Sixteenth 
Amendment  which  is  construed  to  compel  the  Court  to  close  its 
eyes  to  the  substance  of  a  tax  on  income  and  by  disregarding 
the  source  of  the  income  to  leave  the  income  tax  in  the  class  of 
indirect  taxes  where  it  always  belonged  generically.^^  No 
genuine  income  tax  can  any  longer  be  held  a  direct  tax.  The 
only  direct  taxes  are  capitation  taxes  and  taxes,  other  than 
income  taxes,  which  are  in  substance  taxes  on  property  because 

"  Mr.  Justice  Day  in  Flint  v.  Stone  Tracy  Co.  (191 1)  220  U.  S.  107,  ISL  quoting  from 
Chief  Justice  Fuller  in  Thomas  r.  United  States  (1904)  192  U.  S.  363,  370. 

'•220  U.  S.  107,  152. 

»  Chief  Justice  White,  in  Brushaber  v.  Union  Pacific  R.  Co.  (1916)  240  U.  S.  i,  16-17. 

••  Chief  Justice  White,  in  Brushaber  v.  Union  Pacific  R.  Co.  (1916)  240  U.  S.  i.  I7-I9f 
and  Stanton  v.  Baltic  Mining  Co.  (1916)  240  U.  S.  103, 11 2-1 13;  Mr.  Justice  Van  Devanter. 
In  Peck  &  Co.  v.  Lowe  (1918)  247  U.  S.  166,  172-173. 


:/ 


i 


58 


COLUMBIA  INCOME  TAX  LECTURES 


of  its  ownership.  The  Foreign-Built  Yacht  Cases  '^  show  that 
a  tax  on  the  use  of  property  is  not  one  on  property  because  of 
its  ownership.  Other  cases  establish  that  taxes  on  the  transfer 
of  property  are  not  taxes  on  the  property  because  of  its  owner- 
ship.32  si-iii  others  settle  that  taxes  on  acts  or  occupations  are 
not  taxes  on  property  because  measured  by  the  value  of 
property  or  by  income  from  property .**  As  I  did  not  invent 
these  refinements,  I  am  not  concerned  to  defend  them.  Like 
Massachusetts,  there  they  stand.  For  our  purposes  they  are 
so  because  the  Supreme  Court  says  they  are  so.  We  are 
governed  by  them,  however  little  we  may  love  them. 

If  a  tax  on  any  particular  act,  business  or  occupation  is  an 
excise  and  an  indirect  tax,  a  tax  on  all  acts,  businesses  and 
occupations  must  be  an  indirect  tax.  If  indirect,  it  may  be 
levied  by  the  federal  government  without  apportionment 
among  the  states  according  to  population.  It  must  not  inter- 
fere with  the  instrumentalities  of  the  states,**  it  must  not 
reduce  the  compensation  of  the  President  or  the  federal 
judges,'^  it  must  not  be  a  tax  on  exports,'*  and  it  must  not 
offend  the  requirement  of  geographical  uniformity."  But, 
aside  from  these  restrictions,  a  federal  tax  on  business  may  cut 
any  of  the  capers  that  state  excises  may  cut.^^  There  is  a 
hint  that  it  may  cut  more.  The  Chief  Justice  seems  to  think 
that  the  Fifth  Amendment  does  not  limit  the  federal  taxing 
power.  He  has  the  queer  idea  that  the  contrary  notion  would 
mean  that  the  Constitution  confers  a  power  on  the  one  hand 

»»  Cases  in  note  26.  supra. 

32  Cases  in  notes  17.  18.  and  19.  supra. 

w  Cases  in  notes  14,  18,  19.  and  21,  supra. 

**  See  Pollock  v.  Farmers'  Loan  &  Trust  Co.,  note  7.  supra,  and  Collector  v.  Day,  and 
United  States  v.  Railroad  Co.,  note  7.  supra. 

»  Evans  v.  Gore  (1920)  253  U.  S.  245. 

**  See  cases  in  note  25,  supra.  But  a  tax  on  net  income  from  an  exporting  business  it 
not  a  tax  on  exports,  Peck  &  Co.  v.  Lowe  (1918)  247  U.  S.  166. 

•^  In  Brushaber  v.  Union  Pacific  R.  Co.  (1916)  240  U.  S.  i,  24,  Chief  Justice  White 
refers  to  the  cases  establishing  that  the  requirement  that  "all  Duties,  Imposts  and  Excises 
shall  be  uniform  throughout  the  United  States"  exacts  "only  a  geographical  uniformity." 
See  also  his  opinion  in  Billings  v.  United  States  (1914)  232  U.  S.  261,  282. 

w  In  Flint  v.  Stone  Tracy  Co.  (191 1)  220  U.  S.  107,  i53,  Mr.  Justice  Day  says:  "In 
approaching  this  subject  we  must  remember  that  enactments  levying  taxes,  as  other  laws 
of  the  federal  government  when  acting  within  its  constitutional  authority,  are  the  supreme 
law  of  the  land.  The  Constitution  contains  only  two  limitations  on  the  right  of  Congress 
to  levy  excise  taxes;  they  must  be  for  the  public  welfare,  and  are  required  to  be  uniform 


I 


CONSTITUTIONAL     ASPECTS 


59 


and  takes  it  away  on  the  other,  and  he  reminds  us  that  it  is 
"settled  that  the  Constitution  is  not  self-destructive.""  But 
there  is  no  more  incongruity  in  having  the  federal  taxing  power 
limited  by  the  Fifth  Amendment  than  in  having  state  taxing 
power  limited  by  the  Fourteenth  Amendment.  The  existence 
of  power  on  the  one  hand  and  of  constitutional  restrictions  on 
its  exercise  on  the  other  is  of  the  essence  of  our  constitutional 
system.  To  borrow  the  simile  of  Mr.  Ballantine,*"  a  train  is 
not  self-destructive  because  it  has  both  motive  power  and 
brakes.  It  may  well  be  doubted  whether  the  Supreme  Court 
as  a  whole  shares  the  strange  theory  of  the  Chief  Justice.*^ 
Moreover,  he  leaves  a  loop-hole  when  he  tells  us  that  "this 
doctrine  would  have  no  application  to  a  case  where,  although 
there  was  a  seeming  exercise  of  the  taxing  power,  the  act 
complained  of  was  so  arbitrary  as  to  constrain  to  the  con- 
throughout  the  United  States.  As  Mr.  Chief  Justice  Chase  said,  speaking  for  the  Court 
in  License  Tax  Cases,  S  Wall.  462,  471:  'Congress  cannot  tax  exports,  and  it  must  impoae 
direct  taxes  by  the  rule  of  apportionment,  and  indirect  taxes  by  the  rule  of  uniformity. 
Thus  limited,  and  thus  only,  it  reaches  every  subject,  and  may  be  exercised  at  discretion.' 
The  limitations  to  which  the  Chief  Justice  refers  were  the  only  ones  imposed  in  the  Consti- 
tution upon  the  taxing  power." 

By  construction  the  Constitution  is  discovered  to  forbid  excises  on  state  instrumen- 
talities and  excises  which  are  thought  to  diminish  the  compensation  of  the  President  and 
of  federal  judges. 

w  "It  is  also  settled  beyond  dispute  that  the  Constitution  is  not  self -destructive.  In 
other  words,  that  the  powers  which  it  confers  on  the  one  hand  it  does  not  immediately  take 
away  on  the  other;  that  is  to  say,  that  the  authority  to  tax  which  is  given  in  express  terms 
is  not  limited  or  restricted  by  the  subsequent  provisions  of  the  Constitution  or  the  Amend- 
ments thereto,  especially  by  the  due-process  clause  of  the  Fifth  Amendment."  Chief 
Justice  White  in  Billings  v.  United  States  (1914)  232  U.  S.  261,  282. 

"Arthur  A  Ballantine,  "Some  Constitutional  Aspects  of  the  Excess  Profits  Tax." 
Yale  Law  Journal,  vol.  29,  p.  632. 

*>  The  idea,  so  far  as  I  know,  appears  in  the  opinions  of  none  of  the  Chief  Justice's 
colleagues.  Nor  has  the  Chief  Justice  ever  dted  any  one  but  himself  in  support  of  his 
declarations.  In  De  Ganey  r.  Lederer  (1919)  250  U.  S.  376,  the  taxpayer  contended  that 
"the  power  of  the  United  States  to  tax  is  limited  to  persons,  property,  and  business  within 
its  jurisdiction,  as  much  as  that  of  the  state  is  limited  to  the  same  su^^jects  within  its  juris- 
diction," citing  United  States  v.  Erie  R.  Co.  (1882)  106  U.  S.  327.  The  opinion  of  the  Court 
dealt  with  the  question  chiefly  as  one  of  statutory  construction,  but  pointed  out  that  the 
states  were  allowed  to  tax  property  similarly  situated.  After  referring  to  these  cases,  and 
saying  that  it  would  be  "difficult  to  conceive  how  property  could  be  more  completely 
localized  in  the  United  States,"  Mr.  Justice  Day  said:  "There  can  be  no  question  of  the 
power  of  Congress  to  tax  the  income  from  such  securities."  Thus  indirectly  the  power  of 
Congress  was  supported  by  cases  sustaining  similar  powers  of  the  states,  and  there  was 
no  hint  that  Congress  was  immune  from  all  constitutional  restrictions. 

In  Hamilton  v.  Kentucky  Distilleries  &  Warehouse  Co.  (1919)  251  U.  S.  146,  Mr. 
Justice  Brandeis  observed  that  "the  war  power  of  the  United  States,  like  its  other  powers 
and  like  the  police  powers  of  the  States,  is  subject  to  applicable  constitutional  limitations." 


'I 


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elusion  that  it  was  not  an  exertion  of  taxation,  but  a  confisca- 
tion of  property."  ^2  This  says  that,  though  no  federal  tax, 
however  vicious,  can  deny  due  process  of  law,  a  t£ix  may  be  so 
bad  as  to  be  a  tax  in  name  only  and  therefore  void  because  not 
within  the  power  delegated  to  Congress.  The  difference 
between  what  the  Chief  Justice  denies  and  what  he  grants,  if 
any,  is  a  difference  only  of  degree.  But  we  are  assured  that 
no  federal  excise  will  meet  any  greater  obstacles  than  those 
which  the  Fourteenth  Amendment  plants  in  the  way  of  the 
excises  of  the  states. 

We  know  that  state  excises  may  be  measured  in  all  sorts  of 
odd  ways.    To  quote  from  Judge  Dillon : 

Business  or  occupation  taxes  may  be  graduated  in  a  great  variety  of 
ways,  as  by  the  amount  or  value  of  the  stock  in  trade  of  dealers,  the 
marketable  value  of  the  product  of  factories,  etc.,  or  the  quantity  of 
goods  manufactured  or  packed,  the  amount  of  sales  or  business  trans- 
acted, the  amount  of  receipts  from  the  business,  the  gross  earnings  of 
the  business,  the  number  of  persons  employed  in  the  business,  the 
number  of  animals  kept  in  connection  with  the  business,  and  taxes  so 
graduated  are  taxes  on  the  occupation;  and,  although  graduated 
according  to  the  property  used  in  the  business  or  according  to  the 
business  transacted,  are  not  taxes  upon  property.** 

The  federal  government  has  not  exercised  such  variegated 
ingenuity  in  picking  modes  of  assessment,  but  it  has  shown 
enough  to  leave  little  hope  to  those  who  would  impose  con- 
stitutional barriers  against  its  fancy.  None  of  its  measures 
for  assessing  an  excise  has  been  declared  unconstitutional. 
It  has  successfully  applied  its  rates  to  the  gross  receipts  from 
manufacture,^  to  the  value  of  property  sold,*^  or  agreed  to  be 
sold,^  to  the  face  value  of  notes  issued,*^  to  the  tonnage  of 
yachts  used,*^  to  the  weight  of  articles  manufactured  or  held 
for  sale,*^  and  to  the  capacity  to  distill  spirits  whether  the 
distillery  is  run  to  capacity  or  not.^°     Its  specific  taxes  on 

«  240  U.  S.  I,  24-25. 

*> Municipal  Corporations,  Fifth  Edition,  section  1410,  p.  2473. 
**  Spreckels  Sugar  Refining  Co.  v.  McClain,  note  14,  supra. 
*»  Nicol  V.  Ames,  note  18,  supra. 
*•  Thomas  v.  United  States,  note  19,  supra. 
"  Veazie  Bank  r.  Fenno,  note  23,  supra. 

*•  Billings  V.  United  States  and  United  States  v.  Bennett,  note  26,  supra. 
♦•  McCray  v.  United  States,  note  15,  supra;   Cornell  v.  Coyne,  note  16,  supra;   Pattoa 
f.  Brady,  note  17.  supra. 

»•  United  States  v.  Singer,  note  24,  supra. 


CONSTITUTIONAL    ASPECTS 


61 


acts  or  occupations  appear  not  to  have  been  questioned 
because  of  their  measure.  Its  progressive  rates  on  inheri- 
tances *^  and  on  incomes  "  have  been  sustained.  My  Brother 
Ballantine,  who  is  a  real  dirt  lawyer  and  not  a  genteel  academic 
one  and  can  therefore  be  trusted,  assures  us  that  the  vagaries 
of  the  excess-profits  tax  are  likely  to  run  the  gauntlet  of  the 
Supreme  Court."  The  excise  on  the  manufacture  of  oleo- 
margarine was  conceded  by  demurrer  to  be  big  enough  to 
destroy  the  industry.*^  We  know  that  import  duties  are 
sometimes  more  than  the  traffic  can  bear.  Of  course  Con- 
gress is  not  going  to  kill  all  the  geese  that  lay  the  golden  eggs. 
The  ones  it  has  already  successfully  picked  for  slaughter  have 
been  birds  that  could  find  no  shelter  under  the  conception  of 
due  process.  Imports  might  be  prohibited  entirely .^^  The 
states  were  alloWed  to  put  oleomargarine  under  the  ban  by 
their  police  power.^  If  the  tax  on  profits  from  child  labor  is 
sustained,  it  will  not  support  similar  destruction  of  more 
laudable  enterprises  that  have  due-process  protection  against 
state  police  measures.  The  Court  may  allow  Congress  to  tax 
out  of  existence  what  it  or  the  states  might  forbid  directly, 
and  yet  still  refuse  to  permit  the  strangling  of  enterprises  that 
are  without  taint.  Thus  there  still  may  be  scope  for  the 
recognition  that  a  tax  is  not  a  tax  when  it  is  confiscatory. 
But  if  business  may  be  assessed  by  volume  or  by  gross  receipts, 
the  Supreme  Court's  conception  of  income  under  any  particu- 
lar statute  or  under  the  Constitution  is  at  best  but  a  temporary 
shield  against  any  taxes  on  business  that  Congress  is  deter- 
mined to  impose.  An  assessment  that  fails  as  one  on  income  or 
one  measured  by  income  may  succeed  if  changed  to  one  on 
doing  business  and  measured  in  the  specific  way  that  Congress 
directs.  This  is  why  I  venture  to  call  my  subject  a  relatively 
unimportant  one  and  to  advise  you  to  consider  income  taxa- 
tion under  canons  of  fairness,  expediency  and  common  sense, 

•*  Knowlton  r.  Moore,  note  20,  supra. 

"  Brushaber  v.  Union  Pacific  R.  Co.  (1916)  240  U.  S.  i. 

*»  Note  40,  supra. 

•*  McCray  r.  United  States,  note  15,  supra. 

"  Buttfield  r.  Stranahan  (1904)  192  U.  S.  470.  semble, 

*•  Powell  V.  Pennsylvania  (1887)  la?  U.  S.  678. 


( 


62 


COLUMBIA  INCOME  TAX  LECTURES 


M 


and  not  to  trouble  much  about  the  more  majestic  intricacies 
of  constitutional  law. 

II 

Several  instances  have  already  appeared  in  which  Congress 
has  turned  out  to  be  less  hard-hearted  than  an  unclement 
Supreme  Court.  At  various  times  the  Court  sustained  Con- 
gress in  assessing  intercorporate  dividends  ^^  and  dividends 
from  corporate  assets  accumulated  prior  to  191 3,''®  in  denying 
or  limiting  the  deduction  from  gross  receipts  of  the  value  of 
ore  in  place,^^  and  in  limiting  the  deduction  of  interest  on 
indebtedness  paid  by  corporations.^^  Of  all  these  unkindnesses 
Congress  has  since  repented.  It  has  also  changed  the  date 
from  which  corporate  gains  were  reckoned,  by  making  the 
Income  Tax  of  191 3  a  substitute  for  the  Corporation  Excise 
of  1909,  thereby  saving  corporations  from  taxation  on  incre- 
ments to  capital  developing  between  December  31,  1908,  and 
March  i,  1913,  but  not  realized  until  after  the  latter  date.  It 
is  not  certain  that  this  latter  act  of  mercy  was  intentional, 
since  it  required  a  decision  of  the  Supreme  Court  to  prevent 
the  government  from  using  the  Act  of  191 3  to  tax  gains 
accruing  before  its  effective  date  but  realized  thereafter.*^ 
But  this  decision  did  not  prevent  Congress  from  excluding 
corporations  from  the  Act  of  191 3  and  resubjecting  them  to 
the  Act  of  1909.  Congress  acquiesced  when  it  did  not  have 
to.  Moreover,  its  other  amelioriations  of  the  lot  of  taxpayers 
were  entirely  without  any  intervention  by  the  Supreme 
Court.  In  at  least  four  instances  it  abandoned  allowable 
conceptions  of  legal  income  and  went  to  a  sounder  basis  of 
economic  income. 

The  relief  of  intercorporate  dividends  may  be  disposed  of 
briefly.  The  objection  unsuccessfully  urged  against  their 
inclusion  in  the  Act  of  1 913  was  not  that  they  were  not  income, 

*^  Brushaber  v.  Union  Pacific  R.  Co.,  note  52,  supra. 

•»  Lynch  v.  Hornby  (1918)  247  U.  S.  339;   Peabody  v.  Eisner  (1918)  247  U.  S.  347. 

"Stratton's  Independence  v.  Howbert  (1913)  231  U.  S.  399;  Stanton  v.  Baltic  Mining 
Co.  (1916)  240  U.  S.  103. 

•"Anderson  v.  Forty- two  Broadway  Co.  (191S)  239  U.S.  69;  Brushaber  v.  Union 
Pacific  R.  Co.,  note  52,  supra. 

"  Lynch  v.  Turrish  (1918)  247  U.  S.  221, 


CONSTITUTIONAL     ASPECTS 


63 


but  that  it  was  an  unwarranted  discrimination  to  tax  them 
when  dividends  received  by  individuals  were  exempt  from  the 
normal  tax.  The  real  objection  to  taxing  them  is  of  course 
that  a  corporation  is  nothing  but  a  mechanism  by  which 
individuals  do  business  and  that  its  dividends  are  like 
checks  drawn  by  an  individual  to  himself.  Corporate  gains 
go  ultimately  to  natural  persons  and  any  subtraction  by 
taxation  anywhere  is  a  loss  to  the  ultimate  human  recipient. 
Genuine  economic  income  is  not  multiplied  ten-fold  by  going 
through  ten  different  conduits,  for  all  the  legal  doctrine  to  the 
contrary.  Congress  now  acts  on  this  principle  to  the  extent 
of  excluding  dividends  received  by  corporations  and  sparing 
those  received  by  individuals  from  the  mild  ravage  of  the 
normal  tax. 

Whether  the  limitation  on  the  deduction  of  interest  paid  by 
a  corporation  goes  to  the  question  of  what  is  income  may 
occasion  debate.  In  sanctioning  the  limitation  in  the  1909 
Act  the  Supreme  Court  appeared  to  imply  that  it  does,  or  at 
least  that  it  goes  to  the  question  of  what  is  net  income.  The 
first  implication  arises  from  Mr.  Justice  Pitney's  reminder 
that  "the  Act  of  1909  was  not  in  any  proper  sense  an  income 
tax  law,  nor  intended  as  such,  but  was  an  excise  upon  the 
conduct  of  business  in  a  corporate  capacity,  the  tax  being 
measured  by  reference  to  the  income  in  the  manner  prescribed 
by  the  Act  itself."  ^  The  second  implication  springs  from  the 
declaration  in  the  same  opinion  that  it  was  error  to  seek  "a 
theoretically  accurate  definition  of  'net  income',  instead  of 
adopting  the  meaning  which  is  so  clearly  defined  in  the  Act 
itself."  ^  This  seems  to  recognize  pretty  clearly  that  net  income 
does  not  arise  until  the  cost  of  the  use  of  capital  has  been 
deducted.  But  this  limitation  on  the  deduction  of  interest 
paid  was  incorporated  in  the  Act  of  19 13  and  was  sustained  in 
the  Brushaber  Case.**  The  objection  urged  against  it  appears 
to  have  been  only  that  the  disallowance  was  discriminatory 
between  different  corporations  and  between  corporations  and 

"  Anderson  r.  Forty-two  Broadway  Co.  (1915)  239  U.  S.  69.  7a. 

-Ibid. 

•*  Note  52,  supra. 


64 


COLUMBIA  INCOME  TAX  LECTURES 


CONSTITUTIONAL  ASPECTS 


65 


individuals.  The  decision  sanctioning  the  provision  com- 
plained of  is  open  to  several  interpretations.  Technically  it 
can  mean  only  that  the  disallowance  is  not  constitutionally 
vicious  because  not  visited  on  everyone.  Yet  it  is  natural  to 
infer  that  it  means  more.  The  absence  of  any  caveat  or  quali- 
fication in  the  opinion  of  the  Chief  Justice  inclines  us  to  think 
that  he  does  not  regard  a  disallowance  of  deduction  of  interest 
as  an  offence  against  the  Sixteenth  Amendment.  This  would 
mean  that  it  does  not  go  to  the  question  of  gross  income  and 
that  the  Amendment  is  not  restricted  to  net  income.  Yet  it 
would  be  possible  to  insist  that  the  case  involved  only  the 
income  of  a  corporation,  that  power  to  tax  this  income  is  not 
dependent  upon  the  Sixteenth  Amendment  and  that  it  may 
therefore  be  urged  that  in  reckoning  the  income  from  property 
of  one  not  engaged  in  business  the  Amendment  requires  a 
deduction  of  interest  paid  on  capital  borrowed  to  acquire  the 
property.  My  guess  is,  however,  that  no  contention  as  to 
interest  will  find  any  other  ground  to  stand  on  than  that  of 
statutory  interpretation.  This  is  reinforced  by  the  complete 
latitude  allowed  the  states  in  deciding  what  debts  shall  be 
deducted  in  assessing  the  general  property  tax. 

The  taxation  of  corporate  dividends  illustrates  forcibly  the 
distinction  between  legal  income  and  genuine  economic  income. 
These  may  be  taxed  under  the  Sixteenth  Amendment  without 
regard  to  the  question  whether  they  represent  any  actual  gain 
to  the  recipient.  In  Lynch  v.  Hornby,^'"  Hornby  who  had  owned 
some  stock  from  1906  to  191 5  was  taxed  on  some  $17,000  paid 
him  after  1913  from  corporate  accumulations  prior  to  1913. 
In  economics  this  was  nothing  but  a  change  in  the  form  of 
values  which  Hornby  possessed  before  the  Sixteenth  Amend- 
ment was  in  force.  A  similar  catastrophe  took  place  in  Pea- 
body  V.  Eisner, ^^  where  Pea  body  had  to  pay  a  19 14  tax  on  the 
value  of  some  Baltimore  and  Ohio  stock  turned  over  to  him  by 
the  Union  Pacific.  He  was  not  a  bit  richer  from  the  transac- 
tion than  he  had  been  before  191 3  when  the  U.  P.  owned  the 
B.  &  O.  and  he  owned  his  U.  P.  on  which  the  B.  &  O.  was 

•»  Note  s8,  supra. 
••  Note  s8,  supra. 


later  paid  him  as  a  dividend.  Mr.  Justice  Pitney  recognized 
in  the  Hornby  Case  that  the  dividend  "might  appear  upon 
analysis  to  be  a  mere  realization  in  possession  of  an  inchoate 
and  contingent  interest  that  the  stockholder  had  in  a  surplus 
of  corporate  assets  previously  existing""  and  that  "every 
dividend  distribution  diminished  by  so  much  the  assets  of  the 
corporation  and  in  a  theoretical  sense  reduced  the  intrinsic 
value  of  the  stock."  "  Yet  he  says  that  the  Sixteenth  Amend- 
ment allows  Congress  to  treat  the  dividends  as  coming  to  the 
stockholder  "ab  extra  and  as  constituting  part  of  his  income 
when  they  come  to  hand."  *'  Since  no  account  is  taken  of  the 
circumstances  under  which  the  stockholder  acquired  his 
interest  in  the  corporation,  he  may  be  taxed  on  melons  cut  the 
day  after  he  bought  his  stock  at  a  price  based  on  the  general 
knowledge  that  the  melon  was  there  and  the  knife  was  already 
raised  to  slice  it. 

The  only  good  reason  for  this  must  be  that  practical  con- 
venience may  be  thought  to  demand  that  the  corporation  and 
the  stockholder  be  treated  as  altogether  distinct.  The  reasons 
which  Mr.  Justice  Pitney  ventures  are  bad  reasons.  He  says 
that  dividends  are  usually  reckoned  by  the  recipient  as  income 
and  expended  as  such  without  regard  to  whether  they  are  the 
fruit  of  accumulated  corporate  surplus,  and  that  dividends, 
though  they  theoretically  reduce  the  intrinsic  value  of  the 
stock,  demonstrate  the  capacity  of  the  corporation  to  pay 
them  and  quite  probably  increase  the  market  value  of  the 
shares.  This  has  a  goodly  measure  of  truth  when  applied  to 
ordinary  recurring  dividends  but  it  is  palpably  inapplicable  to 
others.  One  who  desires  to  keep  his  capital  intact  does  not 
regard  extraordinary  cash  dividends  as  income  to  be  spent  as 
such,  except  to  the  extent  that  they  represent  a  gain  on  his 
original  investment.  This  lesson  is  one  that  I  had  the  mis- 
fortune to  learn  from  experience.  After  managing  for  others 
some  investments  in  farm  mortgages  for  a  number  of  years, 
I  found  the  principal  reduced  by  several  hundred  dollars, 

"  247  U.  S.  339.  344- 
« Ibid.,  346. 
••  Ihid.,  344, 


L 


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COLUMBIA  INCOME  TAX  LECTURES 


CONSTITUTIONAL  ASPECTS 


:!t', 


With  the  aid  of  an  accountant  I  discovered  that  I  kept  small 
payments  on  principal  in  the  bank  account,  that  from  this  I 
paid  in  advance  the  accrued  interest  on  new  loans  purchased, 
and  then  when  twelve  months  interest  came  in  I  generously 
distributed  it  all  among  the  beneficiaries.  Mr.  Justice  Pitney 
would  make  a  similar  mistake  if  as  agent  or  trustee  he  should 
buy  some  stock  at  a  price  which  includes  the  value  of  an 
undistributed  corporate  surplus  and  then  should  later  divide 
among  the  beneficiaries  an  extraordinary  cash  dividend  which 
that  corporate  surplus  alone  made  possible.  Congress  has 
now  withheld  its  hands  from  dividends  from  corporate  surplus 
accumulated  prior  to  1913.  But  this  is  of  decreasing  impor- 
tance year  by  year  and  it  does  not  save  a  stockholder  from 
being  taxed  on  dividends  which  are  not  genuine  gain  to  his 
capital. 

The  disallowance  of  depletion  of  mines  also  goes  to  the 
question  of  what  is  really  income.  A  miner  without  a  mine  to 
mine  could  produce  no  income  from  mining.  If  he  buys  a  ton 
of  ore  in  place  and  then  sells  it  to  another  while  still  in  place, 
his  income  from  the  transaction  would  at  least  be  limited  to 
the  excess  of  what  he  got  over  what  he  paid.  If  instead  of 
selling  it  in  place,  he  extracts  it  and  sells  it,  his  gain  in  this 
case,  as  in  the  other,  cannot  equal  all  that  he  gets.  If  he  spends 
all  that  he  gets,  his  capital  is  reduced  by  the  amount  that  he 
paid  for  the  ore  in  place.  The  situation  is  not  different  if  he 
buys  a  million  tons  in  place  and  extracts  and  sells  it  a  ton  at 
a  time.  Yet  the  Corpotation  Excise  of  1909,  which  professed 
to  be  measured  by  income,  overlooked  these  patent  considera- 
tions and  allowed  mining  corporations  no  deduction  for  the 
value  in  place  of  the  ore  extracted.  The  complaining  corpora- 
tion in  Stratton's  Independence  v.  Howhert  ^°  was  not  unduly 
modest  in  its  demand  for  a  deduction.  It  insisted  that  the 
value  of  the  ore  in  place  was  to  be  found  by  subtracting  the 
expenses  of  mining  it  from  the  sum  for  which  it  was  sold.  Its 
theory  appeared  to  be  that  the  whole  operation  was  a  profit- 
less conversion  of  capital  assets  from  one  form  into  another. 
Confining  its  decision  to  the  rejection  of  this  theory,   the 

»•  Note  59,  supra. 


67 


Supreme  Court  denied  the  claim  to  a  deduction.  The  Chief 
Justice  and  Justices  McKenna  and  Holmes  dissented;  but 
three  years  later  they  joined  with  their  colleagues  in  Von 
Baumbach  v.  Sargent  Land  Co.  ^i  in  holding  that  no  deduction 
for  depletion  was  required.  The  lessor  of  a  mine  was  assessed 
on  the  royalties  received,  and  the  partial  exhaustion  of  the 
mine  due  to  the  extraction  of  the  ore  by  the  lessee  was  held 
not  to  be  "depreciation**  as  the  term  was  used  by  Congress. 

The  issue  in  these  two  cases  appears  to  be  solely  one  of 
statutory  construction.  From  available  abstracts  of  the 
briefs  it  does  not  appear  that  the  companies  adduced  any 
constitutional  complaint.  The  Court  does  not  discuss  any 
constitutional  question.  In  the  first  case,  however,  Mr. 
Justice  Pitney  observed  that  what  should  be  deemed  income 
within  the  Act  need  not  be  confined  to  what  would  be  taxable 
as  income.  So  the  case  could  not  rightly  be  regarded  as 
authority  for  a  definition  of  income  under  the  Sixteenth 
Amendment.  Nevertheless  the  Supreme  Court  in  Stanton  v. 
Baltic  Mining  Co,'^  allowed  Congress  to  limit  the  allowance 
for  depletion  in  assessing  the  Income  Tax  of  1913,  and  appar- 
ently dismissed  as  immaterial  the  contention  that  allowance 
must  be  made  for  restoration  of  capital  before  receipts  can  be 
taxed  as  income.  It  cannot  be  said  dogmatically  that  the 
contention  was  dismissed,  for  the  Chief  Justice  seems  first  to 
have  warped  it  and  then  to  have  dismissed  it  in  its  warped 
form.  Mr.  Snow  for  the  appellant  argued  that  "nothing  can 
be  mcome  unless  it  represents  a  gain  or  profit."  "If  it  repre- 
sents a  loss  of  capital  assets,"  he  says,  "that  must  first  be 
restored  or  allowed  for,  before  any  income  can  result."  Mr. 
Van  Derlip  as  amicus  curiae  contended  that  "things  which  are 
not  m  fact  income  cannot  be  made  such  by  mere  legislative 
fiat"  and  that  "only  so  much  of  the  receipts  or  royalties  (as 
the  case  may  be)  as  are  in  excess  of  the  capital  investment 
included  in  them  is  income  that  can  be  considered  in  assessing 
an  mcome  tax."  This  seems  a  clear  contention  that  inade- 
quate allowance  for  depletion  makes  the  tax  pro  tanto  one  on 

"  (1917)  243  U.  S.  503. 

*»  (I9i6)  240  U.  S.  103.  note  59,  supra. 


}'.  • 


;< 


( 


68 


COLUMBIA     INCOME     TAX     LECTURES 


CONSTITUTIONAL     ASPECTS 


69 


capital  and  therefore  not  within  the  Sixteenth  Amendment. 
But  the  Chief  Justice  treats  it  as  a  contention  that,  because 
of  the  peculiar  souice  of  income  from  mining,  a  tax  thereon  is 
on  property  because  of  its  ownership,  thus  assuming  it  to  be 
conceded  that  the  assessment  was  on  income.  To  this  he 
answers  that  the  Sixteenth  Amendment  conferred  no  new 
power  of  taxation  but  simply  forbade  looking  at  the  source  of 
income  to  determine  whether  a  tax  in  form  indirect  is  in  sub- 
stance direct.  He  clinches  the  matter  by  saying  that  the 
contention  "asserts  a  right  to  take  the  taxation  of  mining 
corporations  out  of  the  rule  established  by  the  Sixteenth 
Amendment  when  there  is  no  authority  for  so  doing."  ^' 

This,  however,  is  but  one  ground  of  the  decision.  The  other 
is  more  important.  It  is  that  the  tax  complained  of  does  not 
need  the  aid  of  the  Sixteenth  Amendment.  The  Chief  Justice 
tells  us  that  the  idea  that  inadequate  allowance  for  exhaustion 
makes  the  tax  one  on  property  because  of  its  ownership  rests 
upon  a  "wholly  fallacious  assumption  because,  independently 
of  the  effect  of  the  operation  of  the  Sixteenth  Amendment,  it 
was  settled  in  Stratton's  Independence  v.  Howbert,  231  U.  S.  399, 
that  such  teix  is  not  upon  property  as  such  because  of  its 
ownership,  but  a  true  excise  levied  on  the  results  of  the  business 
of  carrying  on  mining  operations."  ^*  This,  however,  was 
settled  in  a  case  in  which  it  was  declared  that  what  Congress 
means  by  income  need  not  be  confined  to  what  is  really  income. 
In  the  Act  of  1913  and  its  successors  Congress  professes  to  be 
taxing  income  as  such.  But  the  Court  says  in  effect  that  it 
does  not  matter  whether  what  Congress  calls  income  is  really 
income  if  it  is  the  proceeds  from  business  which  are  the  proper 
subject  of  an  indirect  tax  without  any  help  from  the  Sixteenth 
Amendment.  It  seems,  then,  that  corporations  have  no  more 
constitutional  protection  against  the  Act  of  191 3  than  they 
have  against  the  Act  of  1909.  If  this  idea  is  carried  to  its  full 
extent,  it  applies  to  any  tax  on  those  engaged  in  business,  since 
Congress  has  no  more  or  no  different  power  over  doing  business 
in  corporate  form  than  over  doing  business  in  other  forms. 

'•240  U.  S.  103,  113. 
^*Ibid.,  114. 


We  see  what  a  wide  door  this  opens  when  we  recall  that  in 
assessing  the  Corporation  Excise,  Congress  was  allowed  a  free 
hand  in  including  income  from  state  securities  and  from 
property  not  actively  employed  in  the  business,  and  in  exclud- 
ing deduction  for  interest  paid  out. 

I  do  not  venture  to  prophesy  that  the  Court  will  go  as  far 
as  it  has  pointed  the  way.  The  pointer  consists  of  logical 
implications,  and  courts  often  refuse  to  follow  logical  implica- 
tions. Nevertheless  it  is  well  to  bear  in  mind  the  possibility 
that  the  Supreme  Court  will  sanction  exactions  under  an 
income  tax  that  it  would  permit  under  a  business  tax.  So 
long  as  the  rose  is  really  the  same  rose,  it  may  smell  as  sweet 
by  any  other  name.  Yet  whether  this  turns  out  to  be  so  or 
not.  Congress  may  escape  from  temporary  barriers  by  picking 
the  right  name.  I  see  no  permanent  constitutional  protec- 
tion against  any  taxes  on  business  that  Congress  is  determined 
to  impose.  I  do  see,  however,  a  willingness  on  the  part  of 
Congress  to  accept  fairer  and  fairer  definitions  of  income. 
In  the  matter  of  allowance  for  mine  depletion  Congress  has 
relented  still  further  than  in  the  Act  of  1913.  In  1916  it 
abandoned  the  five  per  cent,  limitation  on  the  allowance 
and  provided  for  a  reasonable  allowance  "not  to  exceed  the 
market  value  in  the  mine  of  the  product  thereof  which  has 
been  mined  and  sold  during  the  year."  "  The  1918  law  sweeps 
away  even  this  restriction.^*'  It  seems  not  too  much  to  hope 
that  the  time  will  come  when  other  inequities  of  our  federal 
taxing  system  will  be  abolished  and  when  all  we  shall  have  to 
quarrel  with  will  be  the  rates. 

Ill 

In  so  far  as  the  power  of  Congress  to  levy  an  unapportioned 
tax  depends  upon  the  Sixteenth  Amendment,  it  can  assess 
only  what  the  Supreme  Court  regards  as  income,  or  at  most 
what  it  thinks  may  reasonably  be  regarded  as  income. 
Whether  the  test  is  the  former  or  the  latter  will  depend  upon 
the  composition  of  the  bench.    The  word  proved  to  be  a  crystal 

*  Cf.  Von  Baumbach  v.  Sargent  Land  Co.  (1917)  24a  U.  S.  503,  525. 
"Sec.  214  (a)  do). 


70 


COLUMBIA     INCOME     TAX     LECTURES 


CONSTITUTIONAL     ASPECTS 


71 


^1 


f 


after  all,  but  only  by  a  five-to-four  vote.  Minorities  become 
majorities  on  the  Supreme  Court  as  elsewhere.  But  taking 
Eisner  v.  Macotnber  ^^  as  a  datum,  the  Constitution  still  offers 
hope  to  those  who  are  not  engaged  in  business.  Yet  the  case 
proceeded  on  a  ground  so  narrow  that  the  hope  must  be  a 
limited  one.  Stock  dividends  were  held  not  income  because 
they  were  thought  to  involve  neither  payment  nor  receipt. 
They  were  but  a  new  index  of  an  unrealized  appreciation 
of  capital.  To  get  income  from  property  there  must  be  some- 
thing extracted  therefrom.  One  does  not  get  income  merely 
by  growing  richer.  To  have  income,  something  really  new 
must  come  in.  It  can't  come  in  to  one  person  except  as  it 
comes  out  from  some  one  else.  A  scrap  of  paper  will  not 
necessarily  do.  A  corporation  that  issues  a  stock  dividend 
does  no  more  than  a  man  who  gives  his  note.  This  is  all  that 
the  Stock  Dividend  Case  held.  It  did  not  go  on  the  ground 
that  the  stock  dividend  does  not  bring  a  gain  to  the  recipient. 
This  ground  was  not  available  after  extraordinary  cash  divi- 
dends and  dividends  in  property  had  been  held  income  whether 
they  brought  gain  or  not,  and  proceeds  from  ore  had  been  held 
income  without  allowing  for  depletion.  If  we  were  to  seek 
the  Supreme  Court's  conception  of  the  meaning  of  income 
in  the  Sixteenth  Amendment  from  the  cases  in  which  the 
Amendment  has  been  interpreted,  we  should  say  that  segre- 
gation or  receipt  is  a  sine  qua  non  of  income,  but  that  gain  is 
not.  We  should  say  also  that  anything  received  within  a 
given  year  may  be  treated  as  income  for  that  year,  even 
though  it  is  the  cashing  in  of  gains  long  past.  But  cor|X)rate 
dividends  and  mine  depletion  present  peculiar  problems,  and 
the  cases  that  have  disregarded  the  absence  or  the  antiquity 

"  (1920)  252  U.  S.  189.  For  discussions  of  this  decision,  see  Charles  E.  Clark,  "Eisner  v. 
Macomber  and  Some  Income  Tax  Problems,"  Yale  L.  J.,  vol.  29,  p.  735;  Fred  R.  Fairchild. 
"The  Stock  Dividend  Decision,"  Bull.  Nat.  Tax.  Ass'n.,  vol.  S.  P.  208;  Thomas  Reed  Powell. 
"The  Stock  Dividend  Decision  and  the  Corporate  Nonentity,"  Bull.  Nat.  Tax.  Ass'n.. 
vol.  s,  p.  201,  "The  Judicial  Debate  on  the  Taxability  of  Stock  Dividends  as  Income," 
Bull.  Nat.  Tax.  Ass'n.,  vol.  5.  P-  247,  "Stock  Dividends,  Direct  Taxes,  and  the  Sixteenth 
Amendment,"  Colum.  L.,  Rev.,  vol.  20,  p.  536;  A.  M.  Sakolski,  "Accounting  Features 
of  the  Stock  Dividend  Decision,"  Bull.  Nat.  Tax  Ass'n.,  vol.  s.  P-  212;  Edward  H.  Warren, 
"Taxability  of  Stock  Dividends  as  Income,"  Harv.  L.  Rev.,  vol.  33,  p.  885;  and  editorial 
notes  in  Mich.  L.  Rev.,  vol.  18,  p.  689;  Minn.  L.  Rev.,  vol.  4,  p.  462;  U.  Pa.  L.  Rev.,  vol. 
68,  p.  394;   and  Yale  L.  J.,  vol.  29,  p.  812. 


of  gain  in  finding  income  under  the  Sixteenth  Amendment  may 
not  set  the  style  for  cases  where  no  peculiarities  are  discovered. 
Owing  to  these  oddities  in  the  mine  depletion  and  dividend 
cases,  and  to  the  fact  that  the  Stock  Dividend  Case  is  the 
only  one  declaring  unconstitutional  any  assessment  under  the 
Act  of  1909  or  the  Act  of  1913  and  its  progeny,  we  must  get 
our  light  on  the  Supreme  Court's  conceptions  of  income  chiefly 
from  cases  on  questions  of  statutory  construction.  We  can- 
not be  certain  what  these  cases  mean  from  the  standpoint  of 
constitutional  law.  We  cannot  be  sure  that  what  Congress 
was  allowed  to  call  income  under  the  Act  of  1909  it  may  call 
income  under  the  Sixteenth  Amendment.  It  was  clearly  laid 
down  that  an  excise  on  doing  business  in  a  corporate  capacity 
may  be  measured  by  something  not  directly  taxable  as  income. 
While  the  caveat  was  not  taken  advantage  of  in  the  Mine 
Depletion  Case  under  the  Act  of  1913,^*  this  does  not  preclude 
it  from  playing  a  part  in  other  situations.  There  is  a  bare 
possibility,  too,  that  something  held  income  under  an  Income 
Tax  Act,  where  no  constitutional  objection  was  adduced, 
might  be  held  not  income  under  the  Sixteenth  Amendment. 
Of  course  anything  accepted  as  income  under  the  statute 
where  the  draughtsmen  left  the  court  free  to  adopt  any  con- 
ception that  it  chose  would  be  accepted  as  income  under  the 
Amendment.  But  explicit  directions  in  an  income  tax  law 
might  be  applied  as  the  statutory  definition  of  income,  and 
that  definition  later  held  to  transcend  the  meaning  of  income 
in  the  Amendment.  According  to  accepted  canons,  the  Su- 
preme Court  does  not  pass  on  constitutional  issues  unless 
they  are  clearly  raised.  A  still  further  difficulty  in  seeking 
constitutional  law  from  decisions  on  statutory  interpretation 
is  that  we  cannot  be  confident  that  something  excluded  from 
the  meaning  of  income  in  a  statute  will  be  held  not  income 
under  the  Sixteenth  Amendment.  In  the  first  Stock  Dividend 
Case  eight  judges  allowed  the  impression  to  go  forth  that 
income  may  have  a  more  inclusive  meaning  in  the  Constitu- 
tion than  elsewhere.^'    Though  the  distinction  there  acknowl- 

"  Stanton  v.  Baltic  Mining  Co.,  note  59,  supra. 

^*  In  Towne  r.  Eisner  (1918)  24s  U.  S.  418,  425.  Mr.  Justice  Holmes,  in  pointing  out  that 
the  decision  that  stock  dividends  were  not  included  in  the  word  "income"  as  used  in  the 


II 


72 


COLUMBIA     INCOME     TAX     LECTURES 


I 


I 


edged  did  not  find  recognition  in  the  second  Stock  Dividend 
Case,^°  it  is  still  possible  that  in  future  cases  five  judges  instead 
of  four  will  hold  it  applicable.  It  is  a  well-recognized  canon  of 
statutory  construction  that  the  Court  will  lean  to  a  construc- 
tion that  avoids  raising  doubtful  constitutional  questions. 
It  is  a  professed  canon  of  constitutional  interpretation  that 
great  weight  will  be  attached  to  the  judgment  of  the  legisla- 
ture and  that  it  will  be  given  the  benefit  of  every  doubt. 
Both  these  canons  are  honored  in  the  breach  as  well  as  in 
the  observance,  but  it  still  remains  true  that  by  and  large  the 
courts  are  much  more  loath  to  reject  plain  words  in  a  statute 
than  to  restrict  vague  words  to  the  meaning  they  think  most 
appropriate. 

Turning,  then,  to  the  cases  on  statutory  construction  we 
find  five,  all  argued  on  March  4,  5,  and  6,  191 8,  together  with 
the  dividend  cases  of  Lynch  v.  Hornby  *^  and  Peabody  v. 
Eisner.^  The  three  cases  under  the  Act  of  1909,**  decided 
together  on  May  20,  19 18,  had  to  do  with  profits  from  the 
sale  of  corporate  stock  and  of  lumber.  In  each  case  the  gain 
realized  by  the  sale  had  accrued  partly  before  January  i, 
1909,  the  effective  date  of  the  Act,  and  partly  subsequent 
thereto.  In  each  case  the  court  held  that  the  gain  accrued 
after  the  effective  date  of  the  Act  was  taxable  income  and 
that  the  gain  accrued  prior  was  not.  Mr.  Justice  Pitney  said 
that  the  effort  of  the  government  to  reach  the  gain  accrued 
prior  to  the  effective  date  of  the  Act  "finds  no  support  in 
either  the  letter  or  the  spirit  of  the  Act,  and  brings  the  former 
into  incongruity  with  the  latter."  **  Treasury  Regulations  were 
adduced  to  show  that  the  Treasury  regarded  the  statute  as 

Act  of  1913  did  not  involve  the  conclusion  that  they  could  not  be  regarded  as  income  under 
the  Sixteenth  Amendment,  declared:  "But  it  is  not  necessarily  true  that  income  means 
the  same  thing  in  the  Constitution  and  the  act.  A  word  is  not  a  crystal,  transparent  and 
unchanged;  it  is  the  skin  of  a  living  thought  and  may  vary  greatly  in  color  and  content 
according  to  the  circumstances  and  the  time  in  which  it  is  used."  The  decision  was  unani- 
mous, but  Mr.  Justice  McKenna  confined  his  concurrence  to  the  result. 

w  Eisner  v.  Macomber.  note  76,  supra. 

I  Note  58,  supra. 

•»  Note  58,  supra. 

••  Doyle  V.  Mitchell  Brothers  Co.  (1918)  247  U.  S.  179;  Hays  r.  Gauley  Mountain  Coal 
Co.  (1918)  247  U.  S.  189;  United  States  v.  Cleveland,  C.  C.  &  St.  L.  R.  Co.  (1918)  247 
U.  S.  I9S. 

w  247  U.  S.  179,  184. 


CONSTITUTIONAL     ASPECTS 


73 


one  seeking  to  reach  only  gain  arising  after  its  effective  date. 
These  were  thought  to  represent  the  proper  interpretation 
of  the  Act  in  respect  to  profit  from  the  sale  of  lumber  or  cor- 
porate stock  as  well  as  in  respect  to  general  manufacturing 
and  mercantile  transactions.  The  Mine  Depletion  Cases  were 
dismissed  as  presenting  only  a  superficial  analogy  to  proceeds 
from  the  sale  of  timber,  since,  "owing  to  the  peculiar  nature 
of  mining  property,  its  partial  exhaustion  attributable  to  the 
removal  of  ores,  cannot  be  regarded  as  depreciation  within 
the  meaning  of  the  Act."  ^  In  confining  the  Act  to  gains 
arising  after  its  effective  date,  Mr.  Justice  Pitney  said: 

When  the  Act  took  effect,  plaintiff's  timber  lands,  with  whatever 
value  they  then  possessed,  were  part  of  its  capital  assets,  and  a  sub- 
sequent change  of  form,  by  conversion  into  money,  did  not  change  the 
essence.  Their  increased  value  since  purchase,  as  that  value  stood  on 
December  31,  1908,  was  not  in  any  proper  sense  the  result  of  the 
operation  and  management  of  the  business  or  property  of  the  corpora- 
tion while  the  Act  was  in  force." 

So  far  as  appears,  the  decision  on  this  point  was  founded 
solely  on  the  assumed  self-restraint  of  Congress.  There  is 
no  direct  suggestion  that  the  tax  could  not  constitutionally 
have  been  measured  by  the  total  gain  represented  in  the  pro- 
ceeds of  the  property  sold.  The  fact  that  at  a  given  moment 
the  property  is  all  capital  does  not  prevent  some  of  it  from 
becoming  income  upon  a  sale,  as  is  shown  by  the  decision 
that  the  gain  arising  after  1908  is  taxable.  January  i,  1909, 
and  March  i,  1913,  mean  no  more  to  the  economist  than  any 
other  dates.  That  gains  accrued  prior  to  the  enactment  of  a 
law  but  realized  subsequent  thereto  may  be  income  under 
the  statute  and  the  Sixteenth  Amendment  is  clear  from  the 
Mine  Depletion  and  Extraordinary  Dividend  Cases.  That 
a  tax  statute  may  be  retroactive  both  as  to  gains  and  their 
realization  has  been  explicitly  adjudicated.*^  That  the  Court 
will  construe  tax  statutes  to  be  prospective  only,  unless  there 
are  clear  words  to  the  contrary,  is  established.  So  it  is  quite 
likely  that  the  datum  line  which  the  Court  has  taken  in  reckon- 

•»  Ihid.,  188. 
••  Ibid.,  187. 

*^  Stockdale  v.  Atlantic  Insurance  Co.  (1874)  ao  Wall.  323;  Brushaber  v.  Union  Pacific 
R.  Co.,  note  52,  supra. 


74 


COLUMBIA  INCOME  TAX  LECTURES 


r 


i 


ing  gains  is  due  wholly  to  an  attitude  towards  the  statute 
and  not  to  an  attitude  towards  the  Constitution.  So  far  as 
accrued  gains  prior  to  March  i,  1913,  are  concerned,  we  may 
put  the  question  to  one  side.  For  Congress  has  accepted  the 
conclusion  of  the  Supreme  Court  that  in  its  income  tax  laws 
as  well  as  in  its  Corporation  Excise  Act  it  did  not  mean  to  tax 
gains  from  sale  of  property  except  to  the  extent  that  the  gain 
was  subsequent  to  1908  or  to  February  28,  1913,  as  the  case 
may  be.  In  addition  Congress  has  graciously  withdrawn  its 
hand  from  prior  gains  got  in  by  way  of  corporate  dividends  and 
by  way  of  the  extraction  and  sale  of  ore.  The  possibility  of 
a  reversal  of  this  policy  is  a  slim  one  and  is  of  decreasing 
importance  as  191 3  recedes  farther  and  farther  into  the  past. 
However,  there  still  remains  for  explicit  adjudication  the 
issue  whether  gains  in  the  value  of  property  from  March  i, 
191 3,  but  prior  to  the  year  in  which  they  are  realized  by  sale, 
may  be  treated  as  technical  income  under  the  Sixteenth 
Amendment.  That  such  gains  are  not  income  prior  to  their 
realization  seems  to  be  settled  by  Mr.  Justice  Pitney's  discus- 
sion in  the  Second  Stock  Dividend  Case.  That  they  will  be 
held  income  when  realized  is  to  be  anticipated. 

The  theoretical  objections  to  such  a  result  were  met  and 
overcome  in  the  cases  under  the  Act  of  1909.  In  Doyle  v. 
Mitchell  Brothers  Co.,*^  the  efforts  of  counsel  for  the  taxpayer 
were  directed  primarily  to  the  exclusion  of  gains  prior  to  the 
Act.  In  this  they  were  successful.  The  timber  lands  from 
which  the  lumber  was  derived  had  not  enhanced  in  value  since 
the  Act.  The  suit  to  recover  back  the  tax  paid  asked  only 
for  an  allowance  of  the  difference  between  the  stumpage 
value  when  the  lands  were  purchased  and  the  increased 
value  on  December  31,  1908.  The  Court,  therefore,  was  not 
called  upon  to  consider  the  question  of  enhancement  since 
that  date.  Yet  it  appears  to  have  been  argued  that,  since 
the  stumpage  value  at  the  beginning  of  1909  and  at  the 
date  of  cutting  was  the  same,  "the  entire  proceeds  of  the 
conversion  should  be  still  treated  as  the  same  capital,  changed 
only  in  form,  and  containing  no  element  of  income  although 


••  Note  82,  supra. 


C aN S T I T U T I O N A L     ASPECTS 


75 


including  an  increment  of  value."  *'  This  was  dismissed  with 
the  remark  that  "selling  for  profit  is  too  familiar  a  business 
transaction  to  permit  us  to  suppose  that  it  was  intended  to 
be  omitted  from  consideration  in  an  act  for  taxing  the  doing 
of  business  in  corporate  form  upon  the  basis  of  the  income 
received  'from  all  sources'." »°  The  gains  thus  taxed  were 
profits  from  the  process  of  turning  trees  into  boards.  The 
case  did  not  involve  the  ordinary  enhancement  of  property 
realized  only  by  sale.  Yet  Mr.  Justice  Pitney  is  evidently 
thinking  of  such  a  situation  when  he  says: 

"Income  may  be  defined  as  the  gain  derived  from  capital,  from 
labor,  or  from  both  combined." 

Understanding  the  term  in  this  natural  and  obvious  sense,  it  cannot 
be  said  that  a  conversion  of  capital  assets  invariably  produces  income. 
If  sold  at  less  than  cost,  it  produces  rather  loss  or  outgo.  Nevertheless, 
in  many  if  not  in  most  cases  there  results  a  gain  that  properly  may  be 
accounted  as  a  part  of  the  "gross  income"  received  "from  all  sources; 
and  by  applying  to  this  the  authorized  deductions  we  arrive  at  "net 
income."  In  order  to  determine  whether  there  has  been  a  gain  or  loss, 
and  the  amount  of  the  gain,  if  any,  we  must  withdraw  from  the  gross 
proceeds  an  amount  sufficient  to  restore  the  capital  value  that  existed 
at  the  commencement  of  the  period  under  consideration. •! 

The  period   under  consideration  was  the  period    since  the 
effective  date  of  the  statute. 

While  Mr.  Justice  Pitney's  essay  was  dictum  in  the  partic- 
ular opinion  which  contained  it,  it  was  not  dictum  when 
applied,  as  it  was,  to  the  other  two  cases  decided  the  same 
day.  Hays  v.  Gauley  Mountain  Coal  Co.^  involved  corporate 
stock  bought  in  1902  and  sold  in  191 1.  The  taxpayer  cited 
Gray  v.  Darlington  *»  for  the  contention  that  "the  increase  over 
its  original  cost  in  the  value  of  an  investment  held  during  a 
long  term  of  years  by  a  non-trader  does  not  constitute  income 
for  the  year  when  the  investment  is  finally  sold  and  the  increase 
in  value  turned  into  cash."  Gray  v.  Darlington  had  held  that  a 
profit  on  the  sale  in  1869  of  bonds  bought  in  1865  was  none  of 
it  income  for  the  year  1869  under  the  Income  Tax  Act  of  1867, 

••  247  U.  S.  179.  183. 

••  Ibid. 

•1  Ibid..  185. 

«  Note  8a,  supra. 

•»  (1872)  IS  Wall.  63. 


!i 


76 


COLUMBIA  INCOME  TAX  LECTURES 


i 


since  the  Act  of  1867  "looks,  with  some  exceptions,  for  subjects 
of  taxation  only  to  annual  gains,  profits  and  income."  •*  One 
of  the  exceptions  noted  is  in  the  case  of  sales  of  real  estate  when 
the  profits  of  the  sale  are  taxed  "where  the  property  has  been 
purchased,  not  only  within  the  preceding  year,  but  within  the 
two  previous  years."  ®^  This  was  long  before  the  Pollock  Case 
and  the  Sixteenth  Amendment,  and  the  decision  was  based 
wholly  on  the  intention  of  Congress.  In  the  Gauley  Mountain 
Case  Mr.  Justice  Pitney  dismisses  the  Darlington  Case  by 
saying  that  "gains,  profits  and  income  for  the  year"  in  the 
Act  of  1867  "conveys  a  different  meaning  from  'the  entire 
net  income  .  .  .  received  by  it  during  such  year*."  ••  The 
latter  was  said  to  look  "to  the  time  of  realization  rather  than 
to  the  period  of  accruement,  except  as  the  taking  effect  of  the 
Act  on  a  specified  date  (January  i,  1909)  excludes  income  that 
accrued  before  that  date."  "  After  holding  that  interest  could 
not  be  added  to  the  purchase  price  to  ascertain  the  cost  of  the 
property,  Mr.  Justice  Pitney  concluded; 

It  results  that  so  much  of  the  ^210,000  of  profits  as  may  be  deemed 
to  have  accrued  subsequent  to  December  31,  1908,  must  be  treated  as 
part  of  the  "gross  income"  of  respondent.  For  it  is  the  simple  case 
of  a  conversion  of  capital  assets  acquired  before  and  turned  into  money 
after  the  taking  effect  of  the  Act;  and,  as  we  have  shown  in  Doyle  v. 
Mitchell  Brothers  Co.,  this  day  decided,  since  a  conversion  of  capital 
often  results  in  gain,  the  general  purpose  of  the  Act  of  1909  to  measure 
the  tax  by  the  increase  arising  from  corporate  activities,  together  with 
income  from  invested  property,  leads  to  the  inference  that  that  portion 
of  the  gross  proceeds  which  represents  gain  or  increase  acquired  after 
the  taking  effect  of  the  Act  must  be  regarded  as  "gross  income;"  and 
to  this  end  it  must  be  distinguished  from  that  portion  which  represents 
a  return  of  the  capital  value  existing  before.  •• 

Mr.  Justice  Pitney  plainly  thinks  that  realized  gain  from  the 
sale  of  property  is  income.  He  appears  to  think  that  the  gain 
may  be  income  for  the  year  in  which  the  property  is  sold,  no 
matter  how  long  it  has  been  in  accruing.  For  he  says  that  the 
Act  of  1909  "measured  the  tax  by  the  income  received  within 

•*  15  Wan.  63.  6s. 

«  Ibid..  66. 

••  247  U.  S.  189,  192. 

"  Ibid. 

•»  Ibid.,  193, 


CONSTITUTIONAL     ASPECTS 


77 


the  year  for  which  the  assessment  was  levied,  whether  it 
accrued  within  that  year  or  in  some  preceding  year  while  the 
Act  was  in  effect;  but  it  excluded  all  income  that  accrued  prior 
to  January  i,  1909,  although  afterwards  received  while  the 
Act  was  in  effect."  ••  The  learned  Justice's  locution  might 
be  improved  if  he  avoided  speaking  of  "income  accrued"  and 
"income  received."  He  seems  to  jumble  Professor  Haig's 
economic  income  with  the  Supreme  Court's  legal  income. 
According  to  the  Court,  gain  is  not  income  until  realized.  The 
Court  would  do  better  to  stick  to  its  legal  conception  and  use 
the  word  "gain"  rather  than  "income"  when  it  is  speaking  of 
the  period  of  accrual  prior  to  realization.  It  may  be  kind  of 
the  judges  to  lend  aid  to  Professor  Haig  by  their  words  when 
their  deeds  sustain  Professor  Seligman,  but  the  kindness  is 
apt  to  cause  confusion. 

In  guessing  how  much  weight  this  interpretation  of  income 
in  the  Act  of  1909  should  have  in  forecasting  the  interpretation 
of  income  under  the  Sixteenth  Amendment,  note  should  be 
taken  of  the  fact  that  the  court  had  it  specifically  called  to  its 
attention  that  the  gain  in  the  Gauley  Mountain  Case  was  by  a 
non- trader.  And  Mr.  Justice  Pitney  remarks  that  "the 
business  of  trading  in  stocks  is  not  included  among  its  corporate 
powers,  nor  does  it  appear  that,  with  a  single  exception,  it 
ever  bought  or  sold  any."  *°^  So  in  United  States  v.  Cleveland, 
C.C.  &  St.  L.  R.  Co.,^°^  decided  the  same  day,  he  refers  to  the 
fact  that  "the  assets  here  under  consideration  were  not 
acquired  for  the  purpose  of  sale  in  the  manner  of  merchandise, 
but  were  bought  for  investment."  ^^  On  the  other  hand,  the 
government  in  its  brief  argued  that  the  case  of  assets  acquired 
for  a  purpose  incidental  to  a  general  business  and  sold  when  no 
longer  needed  is  different  from  that  of  investments  unconnected 
with  any  business,  and  that  if  Gray  v.  Darlington  ^°*  be  taken 
to  lay  down  a  rule  that  a  conversion  of  capital  does  not  produce 
income  at  all,  and  if  that  rule  be  considered  sound  by  the  Court, 

»•  Ibid.,  192. 

"o  Ibid.,  190. 

>"  Note  82,  supra. 

'«  247  U.  S.  19s.  196. 

••»  Note  92,  supra. 


>l 


I 


i! 


78 


COLUMBIA     INCOME     TAX     LECTURES 


9*' 


t 


fi 


1^- 


it  does  not  apply  to  capital  incidentally  connected  with  a 
business.  Though  this  contention  was  not  mentioned  in  the 
opinion  of  the  Court,  the  fact  that  it  was  made  and  that  it 
covered  not  only  the  case  at  bar  but  the  other  cases  decided  at 
the  same  time  furnishes  a  leverage  for  those  who  wish  to 
contend  that  a  distinction  may  be  drawn  between  sales  of 
capital  by  persons  not  in  business  at  all  and  sales  of  capital  by 
persons  in  business  even  though  the  business  is  not  the  buying 
and  selling  of  the  sort  of  capital  in  question.  Any  decision 
under  the  Corporation  Excise  Tax  Act  is  subject  to  restrictions 
because  of  the  recognition  that  the  measure  of  that  tax  need 
not  be  income  that  would  be  taxable  as  such.  So  there  is 
a  technical  crack  to  serve  as  an  opening  for  those  who  contend 
that  realized  gains  from  sale  of  capital  unconnected  with  any 
business  are  not  income  under  the  Sixteenth  Amendment. 

This  technical  crack  is  not  closed  by  either  of  the  two  de- 
cisions under  the  Act  of  1913.  Both  cases  involved  somewhat 
peculiar  situations.  In  Lynch  v.  Turrish  ^^  a  corporation  went 
out  of  business  and  distributed  its  entire  assets  among  its 
stockholders.  In  Southern  Pacific  Co.  v.  Lowe,^^  the  Southern 
Pacific,  which  owned  all  the  stock  of  the  Central  Pacific,  of 
whose  road  it  was  the  lessee  and  of  which  it  was  formally  a 
debtor,  got  its  debt  cancelled  through  a  book-keeping  arrange- 
ment by  which  the  Central  Pacific  went  through  the  motions 
of  reducing  its  surplus  by  declaring  a  dividend.  Neither  of 
these  transactions  symbolized  any  gain  that  had  accrued  since 
March  i,  1913.  Both  were  held  not  to  yield  any  income  within 
the  meaning  of  the  Act  of  1913.  The  interrelation  between  the 
Union  Pacific  and  the  Central  Pacific  and  the  fact  that  the 
former  had  for  some  time  had  the  funds  represented  by  the 
formal  dividend  were  held  to  take  the  transaction  out  of  the 
rule  of  ordinary  dividends.  So  the  Court  was  free  to  see  whether 
the  formal  transaction  related  to  a  gain  since  the  effective 
date  of  the  Act.  In  denying  the  contention  of  the  Government 
that  the  entire  yield  of  a  conversion  of  capital  is  income,  Mr. 
Justice  Pitney  says  that  the  term  "income"  certainly  has  no 

»w  Note  61,  supra. 

iM  (1918)  247  U.  S.  330. 


CONSTITUTIONAL     ASPECTS 


79 


broader  meaning  in  the  Act  of  1913  than  in  that  of  1909  "and 
for  the  present  purpose  we  assume  that  there  is  no  difference 
in  its  meaning  as  used  in  the  two  acts."  ^^  "This  being  so," 
he  adds,  "we  are  bound  to  consider  accumulations  that  accrued 
to  a  corporation  prior  to  January  i,  1913,  as  being  capital,  not 
income,  for  the  purposes  of  the  Act."  ^°^  Later  he  is  careful 
to  say  that  the  case  turns  on  its  very  peculiar  facts  and  that 
under  the  circumstances  "so  far  as  the  dividends  represented 
the  surplus  of  the  Central  Pacific  that  accumulated  prior  to 
January  i,  1913,  they  were  not  taxable  within  the  true  intent 
and  meaning  of  the  Act  of  191 3."  ^"*  This  invites  the  inference 
that  the  Act  of  191 3  like  that  of  1909  would  reach  realized 
gain  from  sale  of  capital  assets  to  the  extent  that  the  gain 
accrued  after  its  effective  date.  But  here,  as  in  the  cases  under 
the  Act  of  1909,  the  taxpayer  was  engaged  in  business  and  the 
capital  in  question  had  some  relation  to  the  business. 

The  opinion  in  Lynch  v.  Turrish  ^°^  was  written  by  Mr. 
Justice  McKenna.  He  said  all  that  was  called  for  when  he 
declared  that  "if  increase  in  value  of  the  lands  was  income,  it 
had  its  particular  time,  and  such  time  must  have  been  within 
the  time  of  the  law  to  be  subject  to  the  law;  that  is,  it  must 
have  been  after  March  i,  191 3."  "°  Since  there  was  no  increase 
in  value  after  that  date,  the  case  called  for  no  comment  on  the 
question  whether  increase  after  March  i,  1913,  might  be  taxed 
as  income  when  realized.  But  in  answering  the  contention  of 
the  government  that  all  the  gain  realized  by  the  sale  is  income 
and  that  Gray  v.  Darlington  "^  is  inapplicable  because  "the 
Act  of  1 91 3  makes  the  income  taxed  one  'arising  or  accruing' 
in  the  preceding  calendar  year,  while  the  Act  of  1867  makes 
the  income  one  'derived',"  "^  Mr.  Justice  McKenna  observes: 

Granted  that  there  is  a  shade  of  difference  between  the  words,  it 
cannot  be  granted  that  Congress  made  that  shade  a  criterion  of 
intention  and  committed  the  construction  of  its  legislation  to  the 

««  Ibid.,  335. 

>o'  Ibid. 

»»»  Ibid.,  338. 

»••  Note  61,  supra. 

»"247  U.  S.  221,  229. 

I"  Note  92,  supra. 

*"  247  U.  8.  221.  230. 


!/ 


8o 


COLUMBIA  INCOME  TAX  LECTURES 


disputes  of  purists.  Besides,  the  contention  of  the  government  does 
not  reach  the  principle  of  Gray  v.  Darlington,  which  is  that  the  gradual 
advance  in  the  value  of  property  during  a  series  of  years  can  in  no  just 
sense  be  ascribed  to  a  particular  year,  not  therefore  as  "arising  or 
accruing,"  to  meet  the  challenge  of  the  words,  in  the  last  one  of  the 
years,  as  the  government  contends,  and  taxable  as  income  for  that 
year  or  when  turned  into  cash.  Indeed,  the  case  decides  that  such 
advance  in  value  is  not  income  at  all,  but  merely  increase  of  capital,  and 
not  subject  to  a  tax  as  income."* 

This  seems  to  make  no  distinction  between  gain  growing 
after  the  statute  and  that  growing  before.  Yet  it  is  directed 
to  the  support  of  a  proposition  announced  by  the  Circuit 
Judge  that  the  enhancement  in  the  value  of  timber  lands 
during  a  series  of  years  "prior  to  the  effective  date  of  an  in- 
come tax  law,  although  divided  or  distributed  by  dividend  or 
otherwise  subsequent  to  that  date,  does  not  become  income, 
gains  or  profits  taxable  under  such  an  act."  "*  When  we  turn 
to  Gray  v.  Darlington,  which  Mr.  Justice  McKenna  says  has 
not  been  questioned  or  modified,  we  find  it  based  wholly  on 
interpretation  of  a  statute  that  was  said  to  look  with  some 
exceptions  only  to  annual  gains,  profits  and  income.  In  that 
case  Mr.  Justice  Field  said  that  "mere  advance"  in  value  is  not 
income  but  capital.  He  did  not  say  that  income  could  not 
arise  when  the  "mere  advance"  becomes  a  realized  advance. 
He  did  say  that  it  could  not  in  any  just  sense  be  income  for 
the  particular  year  of  realization.  However,  the  case  under  the 
Act  of  1909  holds  that  it  may  be  assessed  as  income  derived 
in  that  year  in  a  tax  on  doing  business  as  a  corporation.  To 
that  extent  the  case  of  Gray  v.  Darlington  was  modified. 
Moreover,  Mr.  Justice  Pitney  leads  us  to  believe  that  he 
thinks  the  Acts  of  1909  and  of  191 3  alike  in  their  intention 
both  to  exclude  gain  accrued  prior  to  their  passage  and  to 
include  gain  accrued  since  and  realized  by  the  requisite  con- 
version. 

Mr.  Justice  Pitney  goes  still  further  in  Eisner  v.  Macomher  "* 
and  adopts  the  definition  of  income  under  the  Act  of  1909  as 
the  definition  under  the  Sixteenth  Amendment.    After  empha- 

"»247  U.  S.  221,  230-231. 

"*  Ihid..  226. 

"»  Note  76,  supra. 


CONSTITUTIONAL     ASPECTS 


81 


Sizing  the  duty  of  the  court  in  applying  the  Amendment  to 
distinguish  between  what  is  income  and  what  is  not,  and  saying 
that  "for  the  present  purpose  we  require  only  a  clear  definition 
of  the  term  'income',  as  used  in  common  speech,  in  order  to 
determine  its  meaning  in  the  Amendment,"  "*  he  continues: 

After  examining  dictionaries  in  common  use  .  .  .  ,  we  find  little 
to  add  to  the  succinct  definition  adopted  in  two  cases  arising  under  the 
Corporation  Tax  Act  of  August  5,  1909  .  .  .  :  "Income  may  be 
defined  as  the  gain  derived  from  capital,  from  labor,  or  from  both 
combined,"  provided  it  be  understood  to  include  profit  gained  through 
a  conversion  of  capital  assets,  to  which  it  was  applied  in  the  Doyle 
Case."' 

And  later  in  the  same  opinion  he  says: 

It  is  said  that  a  stockholder  may  sell  the  new  shares  acquired  in  the 
stock  dividend;  and  so  he  may,  if  he  can  find  a  buyer.  It  is  equally 
true  that  if  he  does  sell,  and  in  so  doing  realizes  a  profit,  such  profit, 
like  any  other,  is  income,  and  so  far  as  it  may  have  arisen  since  the 
Sixteenth  Amendment  is  taxable  by  Congress  without  apportionment. 
The  same  would  be  true  were  he  to  sell  some  of  his  original  shares  at  a 
profit."* 

Plainly  Mr.  Justice  Pitney  thinks  that  gain  produced  by  the 
sale  of  capital  is  income.  His  insistence  in  the  Stock  Dividend 
Case  is  that  this  gain  to  be  income  must  proceed  from,  be 
severed  from,  be  derived  from  the  capital,  be  received  or 
drawn  by  the  recipient,  and  that  it  is  not  enough  to  have  it 
accrue  to  the  capital  or  to  be  merely  "a  growth  or  increment  of 
value  in  the  investment."  ^^'  But  extract  the  gain  from  capital 
and  it  is  income ;  in  so  far  as  the  income  represents  a  gain  since 
the  Sixteenth  Amendment,  it  is  taxable  under  the  Amendment. 
If  Mr.  Justice  McKenna  really  objects  to  this,  it  is  strange 
that  he  concurred  in  all  of  Mr.  Justice  Pitney *s  opinions  as 
well  as  in  his  decisions.  The  latter  specifically  linked  his 
definitions  to  the  meaning  of  income  in  the  Sixteenth  Amend- 
ment. He  was  talking  of  a  situation  in  which  the  taxpayer  is 
not  engaged  in  business.  His  statement  was  dictum  but  it 
was  important  dictum  because  it  was  designed  specifically  to 
allay  apprehension  that  the  decision  that  stock  dividends  are 

"•  252  U.  S.  189.  206-207. 
»"  Ibid.,  207. 
"•/Wd.,  2ia. 
»» Ibid..  207. 


I 


82 


COLUMBIA  INCOME  TAX  LECTURES 


not  income  cuts  the  government  off  forever  from  any  tax  on  the 
gains  transmitted  in  that  way.  Mr.  Justice  McKenna's 
statements  in  Lynch  v.  Turrish  "•*  were  also  dicta.  And  what- 
ever Mr.  Justice  McKenna  may  think,  he  is  only  one  member 
of  the  Court.  Mr.  Justice  Pitney  is  fully  persuaded  that  a 
profit  from  the  sale  of  capital  is  income,  and  that  so  much  of 
it  as  arose  since  the  Sixteenth  Amendment  is  taxable  as  such. 
The  four  dissenting  justices  in  the  Stock  Dividend  Case  who 
approve  of  a  latitudinarian  interpretation  of  "income"  as  used 
in  the  Amendment  will  certainly  make  it  include  profits  from 
the  sale  of  capital,  since  they  made  it  include  a  shift  in  the 
evidence  of  capital  and  did  not  care  whether  it  represented 
profits  or  not.  We  may  be  sure,  therefore,  that  a  majority  of 
the  Supreme  Court  as  now  constituted  are  of  opinion  that  gain 
from  the  sale  of  capital  assets  is  taxable  as  income  to  the  extent 
that  the  gain  arose  since  the  Sixteenth  Amendment  became 
part  of  the  law  of  the  land. 

There  may  be  those  who  find  it  hard  to  believe  that  values 
which  are  wholly  capital  so  long  as  they  inhere  in  some  particu- 
lar stock  or  bond  or  acre  of  land  can  become  part  capital  and 
part  income  by  extraction  from  that  in  which  they  heretofore 
inhered.  This,  however,  is  only  because  the  result  may  offend 
categories  which  they  choose  to  set  up.  Such  categories  may 
be  useful  for  the  particular  purpose  for  which  they  are  invented 
and  still  not  be  sanctified  by  the  Constitution  of  the  United 
States.  If  the  growing  value  of  a  share  of  corporate  stock 
remains  capital  so  long  as  the  company  keeps  hold  of  what 
gives  that  stock  value,  but  becomes  income  the  moment  the 
company  empties  the  value  from  its  surplus  and  pours  it  out 
in  extraordinary  cash  dividends,  a  similar  metamorphosis  may 
as  readily  be  discovered  when  the  stockholder  by  sale  turns 
his  stock  into  cash.  "Realized  gain"  is  a  pretty  sensible  defini- 
tion of  income  for  a  practical  man,  however  it  may  seem  to 
an  expert  conceptualist.  To  say  that  it  cannot  be  income 
because  the  gain  and  its  realization  are  not  wholly  synchron- 
ous is  to  forget  that  realization  is  almost  always  instantaneous 
while  gain  is  usually  gradual.    A  lawyer  does  not  get  his  fee 

"0  Note  6i,  supra. 


CONSTITUTIONAL     ASPECTS 


83 


second  by  second  as  he  earns  it,  nor  a  singer  note  by  note  as 
he  sings  his  song.  A  gardener  hoes  and  weeds  for  some  time 
before  he  takes  his  peas  and  beans  to  market.  So  if  he  lets 
time  and  neighbors  do  his  gardening  for  him,  and  watches  his 
land  grow  values  instead  of  crops,  he  sees  his  gain  growing 
before  it  is  ripe  enough  to  pick.  The  economics  of  an  objec- 
tion to  finding  income  in  the  profit  on  a  sale  of  capital  would 
apply  to  practically  everything  else  held  to  be  income.  Prac- 
tical fiscal  necessity  demands  its  rejection.  Taxes  are  recur- 
rent and  each  tax  has  to  be  for  a  period  of  time.  An  income 
tax  lives  only  on  change.  In  the  case  of  corporate  dividends 
it  may  feed  on  change  in  form  even  though  there  may  be  no 
change  in  value.  In  other  cases  change  in  value  and  change 
in  form  are  both  required.  These  changes  seldom  occur 
wholly  in  unison,  and  often  one  takes  place  in  one  tax  period 
and  one  in  another.  Gain  grows  while  the  grocer  or  doctor 
or  lawyer  extends  credit  to  a  solvent  patron.  The  overflow 
from  the  reservoir  gets  into  the  pipes  before  the  tap  is  opened. 
There  would  be  little  income  from  any  source  if  preliminary 
storage  of  the  yield  of  labor  or  capital  could  not  be  counted. 

This  is  not  to  say  that  the  time  required  for  this  preliminary 
storage  is  not  important.  When  the  pipes  fill  slowly  and  the 
tap  can  be  opened  but  seldom,  the  sensible  man  does  not 
consume  as  fast  as  he  can  draw.  He  will  not  regard  a  week's 
gain  as  a  day's  income,  nor  a  ten  years'  gain  as  a  one  year's 
income.  Mr.  Justice  Field  is  quite  right  when  he  says  that  an 
advance  in  value  over  a  series  of  years  cannot  in  any  just  sense 
be  considered  the  income  of  any  one  particular  year  in  which 
the  advance  is  turned  into  money.  From  the  standpoint  of 
income  taxation  the  question  of  justice  would  hardly  arise  if 
no  greater  tax  were  laid  on  ten  years'  gain  realized  in  a  lump 
than  on  the  same  gain  realized  evenly  year  by  year.  But  our 
progressive  rates  of  assessment  varying  with  the  amount 
realized  in  any  given  twelve  months  penalizes  severely  the 
lumping  of  realization.  Whether  such  penalizing  is  justifiable 
on  the  ground  that  profits  from  the  sale  of  property  are 
usually  not  the  product  of  the  toiling  and  spinning  of  those 
who  enjoy  them  is  for  experts  on  justice  and  social  policy  to 


84 


COLUMBIA  INCOME  TAX  LECTURES 


.:i 


decide.  The  student  of  the  Constitution  can  only  say  that  he 
finds  nothing  in  that  instrument  to  forbid  it.  The  Sixteenth 
Amendment  allows  the  taxation  of  income  from  whatever 
source  derived.  This  is  construed  to  mean  that  the  Court 
cannot  look  at  the  source  of  the  income  to  discover  that  a  tax 
on  income  is  really  a  tax  on  property  because  of  its  ownership 
and  so  a  direct  tax  which  must  be  apportioned  among  the 
states  according  to  population.  If  the  Court  must  disregard 
the  source  when  it  is  ore  in  place  or  an  ancient  corporate 
surplus,  as  has  been  authoritatively  determined,  it  would  seem 
that  it  must  disregard  the  source  when  it  is  an  increment  prior 
to  the  year  of  realization.  So  that  if  we  grant  that  the  realized 
gain  is  income  we  need  not  care  whether  it  is  income  for  a 
particular  year.  Nothing  in  the  language  of  the  Constitution 
restricts  Congress  to  the  taxation  of  annual  income.  Nor 
would  the  fact  that  lumped  realized  gains  may  not  be  a  single 
year's  income  in  economics  or  accounting  prevent  it  from 
being  a  single  year's  income  in  law.  Where  two  elements, 
gain  and  its  realization,  are  both  essential  to  produce  income, 
the  income  may  be  thought  to  arise  as  a  legal  fact  when  the 
second  requisite  is  added  to  the  first.  If  this  is  true  of  corporate 
dividends  and  proceeds  from  sale  of  ore,  whether  gains  or 
not,  why  should  it  not  be  true  of  actual  gains  from  the  sale 
of  other  property?  The  result  may  be  undesirable,  but  it  is 
not  therefore  unconstitutional. 

It  seems  to  be  agreed  that  profit  from  the  sale  of  capital 
assets  is  income  to  one  who  is  in  the  business  of  buying  and 
selling.  There  is  but  one  economic  difference  between  such 
continuous  and  repeated  buying  and  selling  and  an  isolated 
instance.  Numerous  overlapping  transactions  tend  to  make 
the  annual  gain  correspond  somewhat  to  the  annual  realization 
of  gain.  No  such  factor  is  present  when  an  investor  makes  a 
casual  advantageous  sale.  This  difference,  however,  relates 
to  the  question,  not  whether  a  realized  profit  is  income,  but 
whether  it  is  all  income  for  the  year  in  which  the  realization 
occurs.  It  would  require  a  little  legerdermain  for  a  court  to 
hold  any  of  it  income  for  a  year  prior  to  its  realization,  after 
the  clear  adjudication  that  it  cannot  be  income  until  realized. 


CONSTITUTIONAL     ASPECTS 


85 


Such  tricks  of  relating  back  are  now  and  then  performed  by  the 
law,  so  that  the  feat  is  not  impossible.  It  would  reach  a 
practical  result  quite  in  accord  with  common  sense.  Strong 
arguments  may  be  adduced  why  Congress  should  treat  the 
present  realization  of  past  gains  as  new  increment  to  the 
incomes  for  the  years  in  which  the  gains  developed.  The  Act 
of  1 91 7  took  a  step  in  this  direction  by  applying  the  rates  of 
past  years  to  dividends  from  corporate  gains  of  past  years. 
The  step  was  almost  completely  reversed  later,  and,  under  the 
Treasury  interpretation,  the  Act  of  191 7  looked  to  the  past 
only  for  the  percentum  of  the  rates.  The  income  from  corporate 
dividends  was  still  treated  as  income  for  the  year  in  which  it 
was  realized,  and  the  progression  was  determined  by  reference 
to  the  income  of  that  year.  A  case  arising  under  this  practice 
is,  however,  no  worse  than  that  of  a  lawyer  who  works 
three  years  for  a  $30,000  fee  without  the  possibility  of  keeping 
his  books  on  an  accrual  basis — either  because  he  could  not 
tell  in  advance  what  his  fee  would  be  or  because  he  had  no 
funds  to  pay  the  tax  until  the  fee  came  in.  All  such  inequities 
deserve  legislative  consideration.  Nevertheless  it  is  hard  to 
find  for  them  any  balm  in  the  Constitution.  Even  if  it  is 
conceded  that  profits  from  past  gains  are  presently  realized 
past  income,  the  Constitution  does  not  forbid  the  taxing  of 
past  income.  This  was  settled  in  the  Brushaber  Case  in  which 
Chief  Justice  White  said  that  the  Sixteenth  Amendment  is 
satisfied  if  the  retroactivity  does  not  go  back  of  its  enactment, 
and  that  objections  based  on  other  clauses  of  the  Constitution 
are  foreclosed  by  Stockdale  v.  Atlantic  Insurance  Company?*^ 
His  approval  of  that  case  includes  a  sanction  of  a  tax  on 
income  of  the  previous  year  though  one  tax  on  it  had  already 
been  paid. 

IV 

This  covers  the  questions  which  the  Supreme  Court  has 
already  considered.  Other  interesting  issues  remain  to  be 
settled.  The  most  troublesome  will  be  those  which  arise  from 
the  combination  of  a  number  of  transactions  indulged  in  by 

"»  Note  86,  supra. 


86         COLUMBIA     INCOME     TAX     LECTURES 


the  same  taxpayer.    Some  may  bring  a  profit,  others  a  loss. 
Some   losses  will  be  realized,  others  will  be  unrealized.     It 
seems  clear  that  if  the  assessment  includes  only  realized  gains 
it  may  confine  its  deductions  to  realized  losses.    It  is  hard  to 
find    any   constitutional    protection   against    taxing   realized 
gains  and  disregarding  realized  losses.    The  Sixteenth  Amend- 
ment is  not  restricted  to  net  income.    It  says  "incomes,  from 
whatever  source  derived."    The  Brushaber  Case  settles  that 
Congress  may  tax  some  incomes  and  not  others.    What  for- 
bids it  to  separate  a  man's  income  from  his  loss  and  to  tax 
the  former  and  disregard  the  latter?    Certainly,  if  the  realiza- 
tion of  the  loss  is  on  paper  only,  as  in  the  case  of  wash  sales, 
the  Court  will  disregard  it  as  it  disregarded  the  paper  trans- 
actions in  the  Stock  Dividend  Case  and  the  Southern  Pacific 
Case.     For  anything  that  appears  in  the  Constitution  or  in 
the  cases,  Congress  may  levy  on  gross  income.    As  a  matter 
of  statutory  interpretation,  gross  income  from  the  sale  of  a 
particular  piece  of  property  does  not  arise  until  after  the 
deduction  of  its  capital  value  at  the  appropriate  antecedent 
date,  except  in  the  aberrant  instance  of  extracts  from  mines. 
Sales  at  a  loss  would  not  produce  even  gross  income.    But  it 
does  not  follow  that  such  losses  must  be  deducted  before 
profitable  transactions  produce  gross  income.     It  may  well 
be  that  the  Court  will  view  the  question  of  deducting  losses 
as  one  which  concerns  only  the  proper  subtractions  to  re- 
duce gross  income  to  net.     If  this  turns  out  to  be  the  case, 
the  Court  will  consider  the  question  of  deductions  only  as 
one  of  statutory  interpretation.     The  opinion  of  the  Chief 
Justice  in  the  Brushaber  Case  in  its  roundabout  way  informs 
us  that  neither  the   Fifth   nor  the  Sixteenth  Amendments 
nor   the    requirement   of   uniformity   hampers    Congress   in 
deciding  what  deductions  to  allow  from  gross  income. 

Above  all  it  is  to  be  remembered  that  Congress  is  restricted 
to  the  taxation  of  income  only  when  the  tax  is  one  that  would 
have  been  regarded  as  a  direct  tax  within  the  Pollock  Case. 
I  had  long  assumed  that  the  Pollock  Case  applied  only  to 
rents,  interest  and  dividends;  that  only  a  tax  on  the  ordinary, 
normal,  recurring  fruits  of  property  was  regarded  as  a  tax  in 


CONSTITUTIONAL     ASPECTS 


«7 


substance  on  the  property  because  of  its  ownership.     Only 
such  taxes  have  that  element  of  unavoidable  demand  which 
is  referred  to  in  the  opinions  as  the  basis  for  distinguishing 
between  direct  and  indirect  taxes.     But  Mr.  Justice  Pitney 
in  the  Stock  Dividend  Case  assumes  that  the  Pollock  Case 
applies  to  "taxes  upon  rents  and  profits  of  real  estate  and  upon 
returns  from  investments  of  personal  property."  *^   And  Mr. 
Justice  Peckham  in  Nkol  v.  Ames,^^  in  holding  a  tax  on  sales 
at  exchanges  to  be  indirect  tax,  says  that  such  a  tax  "differs 
radically  from  a  tax  upon  every  sale  made  in  any  place"  and 
that  the   latter  "is  really  and   practically  upon   property," 
because  it  "takes  no  notice  of  any  kind  of  privilege  or  facility, 
and  the  fact  of  the  sale  is  alone  regarded."  ^**   This  is  dictum, 
but  it  finds  some  support  in  the  decision  in  the  Stock  Dividend 
Case,  in    that  the  Court  there  seemed  to  assume  without 
discussion  that  a  tax  on  a  stock  dividend  is  a  tax  on  the  prop- 
erty in  the  parent  stock  because  of  its  ownership.     I  do  not 
see  why  the  issue  or  receipt  of  a  stock  dividend  is  not  as  much 
a  proper  subject  of  indirect  taxation  as  a  tax  on  an  agreement 
to  sell  a  share  of  stock  or  on  the  use  of  a  foreign-built  yacht. 
I  do  not  see  how  a  tax  on  the  sale  of  property  or  the  proceeds 
thereof  or  the  gain  therein  is  a  tax  on  the  property  because  of 
its  ownership.    It  may  be  that  the  Supreme  Court  now  thinks 
that  the  principle  of  the  Pollock  Case  is  that  taxes  on  the  yield 
of  property  itself,  whether  by  sale  or  otherwise,  are  in  sub- 
stance taxes  on  the  property  itself.    If  so,  that  yield  must  be 
income  in  order  to  be  subject  to  an  indirect  tax. 

This  does  not  apply  however,  where  the  yield  represents 
something  more  than  intrinsic  enhancement  of  the  property 
itself.  I  say  "intrinsic  enhancement,"  to  distinguish  the 
increment  which  inheres  in  the  property  itself  from  the  gain 
realized  by  changing  its  form  or  displaying  it  in  an  emporium 
and  then  selling  it.  The  gains  of  a  manufacturer  or  regular 
trader  or  the  process  of  manufacturing  or  trading  seem  to  be 
thought  of  as  subjects  of  indirect  taxation  which  is  not  taxa- 

"»  252  U.  S.  189,  205. 
»*•  Note  18,  supra. 
»•  173  U.  S.  509.  521. 


ill 


II 


n 


88 


COLUMBIA  INCOME  TAX  LECTURES 


tion  on  the  property  itself  because  of  its  ownership.  Accord- 
ing to  the  opinion  of  the  Chief  Justice  in  the  Baltic  Mining 
Case,  a  tax  on  such  operations  is  an  indirect  tax  independently 
of  the  effect  of  the  Sixteenth  Amendment.  Being  indirect, 
it  may  be  measured  in  other  ways  than  by  income,  net  or 
gross.  If  Congress  clearly  indicates  how  it  wishes  such  taxes 
to  be  measured,  it  cannot  matter  that  it  calls  its  measure 
"income"  when  the  court  thinks  that  in  truth  it  is  not.  "In- 
come" as  used  by  Congress  in  any  tax  which  is  in  no  respect 
within  the  Pollock  Case  need  not  be  "income"  that  is  taxable 
as  such  under  the  Sixteenth  Amendment.  The  Sixteenth 
Amendment  does  not  limit  the  power  previously  enjoyed  by 
Congress.  It  merely  removes  the  requirement  of  apportionment 
from  taxes  on  income  that  are  in  substance  taxes  on  property. 
Clearly,  therefore,  any  tax  on  the  proceeds  of  business  trans- 
actions or  on  business  done  or  on  being  in  business,  which  is 
unmixed  with  a  tax  on  the  sort  of  income  or  proceeds  that 
are  within  the  shelter  of  the  Pollock  Case,  has  nothing  to  fear 
from  the  requirement  that  direct  taxes  be  apportioned  among 
the  states  according  to  population.  In  respect  to  such  a  tax, 
the  federal  government  has,  at  the  very  least,  all  the  latitude 
in  finding  modes  of  assessment  that  the  states  enjoy  in  measur- 
ing their  excises. 

This  is  not  to  say  that  the  present  Income  Tax  Act  may  get 
at  any  proceeds  that  might  be  reached  by  an  excise  on  business. 
If  the  taxpayer's  return  includes  amounts  that  could  not  be 
reached  under  the  Pollock  Case  and  which  can  therefore  be 
taxed  only  under  the  Sixteenth  Amendment,  the  Supreme 
Court  may  well  hold  that  he  may  exclude  from  his  return 
anything  that  is  not  income  within  the  meaning  of  the  Amend- 
ment. This  seems  to  me  the  ground  on  which  the  Stock 
Dividend  Decision  should  have  been  put.  It  should  have 
recognized  that  a  separate  tax  on  stock  dividends  would  have 
been  an  indirect  tax,  but  have  held  that  a  transaction  or  the 
proceeds  thereof  on  which  a  tax  would  be  an  indirect  tax  may 
not  be  included  in  the  assessment  of  an  income  tax  proper 
unless  the  proceeds  are  genuine  income.  But  the  theory  on 
which  the  case  proceeded  leaves  us  in  doubt.    The  doubt,  how- 


CONSTITUTIONAL     ASPECTS 


89 


ever,  should  be  confined  to  cases  where  the  taxpayer's  return 
includes  items  which  would  not  be  taxable  except  for  the  Six- 
teenth Amendment.  If  the  items  in  the  return  are  exclusively 
proceeds  from  business,  a  tax  thereon  is  an  indirect  tax 
whether  within  the  Sixteenth  Amendment  or  not.  Of  course 
it  is  possible  for  the  Court  to  say  that  when  Congress  professes 
to  tax  only  income,  it  will  be  held  to  its  professions.  However, 
any  such  restriction  would  readily  be  overcome  by  a  simple 
change  in  the  wording  of  the  law.  The  reason  why  genuine 
income  should  not  be  mixed  with  something  else  is  because 
the  rates  are  based  on  what  it  is  thought  genuine  income  can 
stand.  Since  both  the  proceeds  from  business  and  the  income 
proper  are  separately  taxable,  their  confusion  in  a  single  tax 
affects  only  the  rates  of  levy.  Such  a  confusion  which  affects 
only  the  rates  was  sanctioned  in  Maxwell  v.  Bugbee  ^^  which  in 
effect  allowed  New  Jersey  to  look  to  extra-state,  non-taxable 
assets  in  order  to  fix  the  rate  of  an  inheritance  tax  on  the  New 
Jersey  assets  passing  by  the  will  of  a  nonresident.  The  prin- 
ciple of  that  five-to-four  decision  would  stand  in  the  way  of 
constitutional  relief  from  the  commingling  under  considera- 
tion. But  the  principle,  happily,  is  not  one  of  universal  appli- 
cation. Indeed  an  apology  is  needed  for  its  application  in 
any  case. 

In  closing,  a  word  should  be  said  about  rates  and  about 
double  taxation.  In  a  recent  case  involving  a  state  tax,  Mr. 
Justice  Holmes  said  that  the  Fourteenth  Amendment  no 
more  forbids  double  taxation  than  it  does  doubling  the  amount 
of  the  tax.^^  Nothing  in  the  Constitution  forbids  taxing  the 
income  of  the  corporation  and  taxing  the  dividends  of  the 
stockholders.  Each  tax  may  be  progressive.  This  was 
settled  in  the  case  of  personal  income  on  the  authority  of  the 
cases  sustaining  progressive  inheritance  taxation.  Nice  theo- 
retical distinctions  may  be  drawn  between  state  progressive 
inheritance  taxation  and  federal  levies  of  the  same  character. 
Similar  distinctions  exist  between  progressive  inheritance 
taxation  and  progressive  income  taxation.    But  these  distinc- 

«» (1919)  250  U.  S.  525. 

"•  Ft.  Smith  Lumber  Co.  v.  Arkansas  (1920)  251  U.  S.  S32,  533- 


i 


90         COLUMBIA     INCOME     TAX     LECTURES 

tions  have  not  been  regarded  by  the  courts.    Though  the  pro- 
gressive tax  on  corporations  has  not  been  the  subject  of  explicit 
adjudication  in  the  Supreme  Court,  it  cannot  be  doubted  that 
it  will  be  sustained  for  the  reasons  given  by  Mr.  Ballantine  in 
his  admirable  article  on  the  Excess  Profits  Tax  in  the  Yale 
Law  Journal}^''    Yet  the  Excess  Profits  Tax,  even  if  it  were 
made  wholly  equitable  as  between  different  corporations,  is 
haphazard  and  slapdash   in  its  treatment  of  stockholders. 
What  they  have  paid  for  their  stock  depends  in  most  cases  on 
anticipation  of  earnings.    Earnings  of  a  hundred  per  cent,  on 
what  has  been  put  into  the  corporate  property  may  be  earn- 
ings of  only  ten  per  cent,  on  what  the  present  stockholders 
have  paid  for  their  stock.    In  reality  it  is  the  stockholders  who 
pay  the  tax.     But  the  artificial  idea  that  the  corporation  is 
entirely  distinct  from  its  stockholders  causes  the  courts  to 
neglect  the  substance  here  as  they  neglect  it  in  deciding  what 
is  a  fair  return  on  a  fair  value  for  the  purposes  of  rate  regula- 
tion.   If  it  were  to  be  wholly  neglected,  corporations  should  be 
allowed  to  deduct  dividends  as  well  as  interest  payments  on 
bonds.    If  we  wish  higher  taxation  of  unearned  incomes  than  of 
earned  incomes,  we  could  know  better  just  what  we  were  doing 
if  we  went  about  it  directly  instead  of  accomplishing  it  to  an 
extent  in  putting  a  progressive  tax  on  corporate  earnings  on 
one  basis  and  a  progressive  tax  on  those  same  economic  earn- 
ings on  another  basis  when  they  pass  on  to  the  stockholders. 
But  these  economic  oddities  and  inequities  raise  no  questions 
of  constitutional  law.     They  help  to  show  why  I  end  as  I 
began  by  saying  that  the  constitutional  aspects  of  federal 
income  taxation  are  relatively  unimportant.    My  paper  might 
almost  be  summarized  as  was  that  of  a  distinguished  psy- 
chologist.   A  friend  told  him  how  much  he  enjoyed  his  lecture. 
"But  you  weren't  there,"  was  the  surprised  response.    "No," 
was  the  rejoinder,  "but  Jones  gave  me  an  excellent  summary 
of  it.    He  told  me  that  you  spoke  on  imageless  thought  and 
said  that  there  wasn't  any." 

"'  CU.  supra.,  note  40. 


THE  LEGAL  FORCE  AND  EFFECT  OF 
TREASURY  INTERPRETATION 

BY 

Fred  T.  Field 

Rulings  of  the  Treasury  which  involve  interpretations  of 
income  tax  statutes  are  of  two  classes:  (i)  rulings  in  par- 
ticular cases,  and  (2)  rulings  of  general  application.  Knowl- 
edge of  rulings  made  in  particular  cases  may  be  left  to  inference 
from  the  acts  of  the  Treasury.  Ordinarily,  however,  such  a 
ruling  is  embodied  in  a  letter  to  the  taxpayer  in  the  particular 
case.  Such  rulings  may  find  their  way  into  the  Bulletin  of 
Income  Tax  Ridings  published  by  the  Treasury  in  the  form 
of  Solicitor's  Opinions,  Solicitor's  Memoranda,  Committee  on 
Appeals  and  Review  Recommendations  and  Memoranda  (suc- 
ceeding to  Advisory  Tax  Board  Recommendations  and 
Memoranda)  and  Office  Decisions.  Rulings  of  general  appli- 
cation are  ordinarily  embodied  in  Treasury  Regulations  or 
Treasury  Decisions,  though  occasionally  such  rulings  of 
lesser  importance  are  embodied  in  so-called  Treasury  Mimeo- 
graphs or  in  Solicitor's  Opinions  or  Memoranda  or  Com- 
mittee on  Appeals  and  Review  Recommendations  and 
Memoranda. 

The  authority  to  make  rulings  is  to  be  found  either  in  the 
express  statutory  delegation  to  the  Commissioner  of  Internal 
Revenue  acting  "under  the  direction  of  the  Secretary  of  the 
Treasury"  of  the  general  supervision  of  the  assessment  and 
collection  of  income  taxes,^  the  express  statutory  delegation 
of  power  to  the  Commissioner  to  do  various  acts  involved  in 
such  collection  and  assessment  and  in  the  necessary  implica- 
tions  from   these  delegations  of   power,   or   in   the  express 

»  Rev.  Sut.,  Sec  321. 


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92         COLUMBIA     INCOME     TAX     LECTURES 


Xijiu, 


<;•; 


Statutory  delegation  of  power  to  the  Commissioner  "with  the 
approval  of  the  Secretary"  to  make  all  needful  rules  and 
regulations  for  the  enforcement  of  the  provisions  of  the 
income  tax  statutes.^  To  a  limited  extent  collectors  and 
subordinate  officers  have  statutory  duties  to  perform  which 
involve  interpretation  of  income  tax  laws,  but  as  these  duties 
are  performed  under  the  general  supervision  of  the  Com- 
missioner substantially  all  Treasury  rulings  are  to  be  attri- 
buted to  him  acting  under  the  direction  or  with  the  approval 
of  the  Secretary. 

I.  Rulings  in  Particular  Cases.  We  consider  first  rulings 
in  particular  cases.  Such  rulings,  as  already  indicated,  may 
be  merely  implied  from  acts  of  the  Treasury  or  may  be  ex- 
pressly stated.  Whether  expressly  stated  or  not,  interpretation 
of  statute  is  involved  in  each  act  of  the  Treasury,  whether  it 
be  assessment,  collection,  refund  or  any  act  incident  to  one 
of  these  major  acts.  To  the  extent  that  one  of  these  acts  is 
binding  the  interpretation  of  statute  involved  therein  is 
binding  in  the  particular  case.  A  preliminary  inquiry  is, 
therefore,  as  to  the  legal  force  and  effect  of  these  acts  of  the 
Treasury. 

(a)  Acts.  Assessment  is  ordinarily  the  first  act  of  the 
Treasury  in  dealing  with  a  particular  case.  Requirements 
as  to  the  keeping  of  records  and  the  making  of  returns  are 
usually  of  general  application  though,  of  course,  in  the  en- 
forcement of  such  requirements  particular  taxpayers  must  be 
dealt  with.  There  is,  however,  statutory  authority  for  cer- 
tain acts  with  respect  to  particular  taxpayers  which  are  to  be 
performed  before  assessment.  Thus,  for  example,  the  Com- 
missioner may  require  a  person  to  make  such  statements  as 
he  deems  sufficient  to  show  whether  or  not  such  person  is 
liable  to  tax.^  He  may  extend  the  time  for  filing  returns  and 
paying  the  tax  and  may  on  the  other  hand  in  certain  cases 
advance  the  time  for  payment  of  the  tax.*  So,  apparently, 
the  Commissioner  may  with  the  approval  of  the  Secretary 

*  1918  Law,  Sec.  1309. 

*  Ibid.,  Sec.  1305. 

*  Ibid.,  Sec.  250. 


^ 


i 


FORCE  OF  TREASURY  INTERPRETATION  93 

require  the  use  of  inventories  in  a  particular  case.'  His 
approval,  moreover,  is  required  for  a  change  in  the  fiscal  year 
for  which  a  particular  taxpayer  files  his  return.'  I  pass  these 
and  similar  acts  without  further  discussion. 

Assessment — the  determination  by  the  Commissioner  of 
the  amount  of  tax  due  from  an  individual  or  corporation — 
plays  an  important,  though  not  an  essential,  part  in  income 
tax  procedure.  Though  an  assessment  is  not  essential  to 
establish  obligation  ^  and  suit  may  be  brought  without 
assessment,*  an  assessment  is  prima  facie  evidence  in  a  suit  by 
the  United  States  of  the  amount  due '  and  an  assessment  is 
the  basis  for  distraint.  (Probably  in  the  case  of  the  Revenue 
Act  of  191 8  a  taxpayer's  computation  is  a  sufficient  basis  for 
distraint  for  the  first  instalment  of  the  tax  shown  by  such 
computation  and  possibly  for  later  instalments).  Thus 
assessment  by  the  Commissioner  (and  probably  self-assess- 
ment) even  though  based  on  erroneous  interpretation  is 
effective  to  the  extent  that  it  warrants  the  taking  of  a  tax- 
payer's property,  subject,  however,  to  appeal  to  the  courts, 
upon  questions  as  to  liability  and  amount  of  tax.  An  assess- 
ment is,  therefore,  protection  to  the  collector  in  making 
collection.*®  An  assessment  by  the  Commissioner,  however, 
does  not  bind  him  not  to  make  an  additional  assessment 
within  the  time  allowed  by  the  statute  for  making  assess- 
ments, nor  prevent  the  Government  from  bringing  suit  for  an 
amount  greater  than  the  assessment."  Abatement  is  merely 
correction  of  assessment. 

Collection  of  a  tax  places  the  burden  on  the  taxpayer  of 
showing  that  the  tax  is  illegal  or  excessive  in  amount  and 
concludes  the  taxpayer  unless  he  appeals  within  the  period 
fixed  by  statute.  The  act  of  collection  thus  affects  a  tax- 
payer's rights  even  though  it  is  based  upon  an  erroneous 
interpretation.    Collection,  like  assessment,  does  not  bar  the 

•/Wd.,  Sec.  203. 

*  Ibid..  Sec.  212. 

»  Dollar  Savings  Bank.  v.  U.  S.,  19  Wall.  227. 

•  U.  S.  V.  Grand  Rapids  &  Indiana  Railway  Co.,  239  Fed.  IS3. 
» U.  S.  V.  Rindskopf,  105  U.  S.  418- 

>•  Harding  v.  Woodcock,  137  U.  S.  43- 

"  N.  Y.  Life  Insurance  Co.  r.  Anderson.  257  Fed.  576. 


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94 


COLUMBIA     INCOME     TAX     LECTURES 


FORCE     OF    TREASURY     INTERPRETATION      95 


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■   I 


Government  from  further  assessment  and  collection.  A  com- 
promise made  in  accordance  with  the  provisions  of  the  statute  " 
is  conclusive  upon  both  Government  and  taxpayer  even  though 
entered  into  by  reason  of  an  erroneous  interpretation  of 
statute.^' 

The  Commissioner  in  accordance  with  regulations  of  the 
Secretary  may  refund  taxes  erroneously  or  illegally  assessed 
or  collected."  Application  for  such  a  refund  must  be  made  to 
the  Commissioner  before  suit  can  be  brought  in  court.  If  the 
Commissioner  rejects  the  claim  or  fails  to  act  within  six 
months  suit  may  be  entered.*^  If,  however,  he  allows  the 
claim  his  decision  cannot  be  reviewed  as  to  the  facts  but  may 
be  reviewed  as  to  the  law  by  the  Court  of  Claims.  Such  a 
question  of  law  would  be  raised  by  the  Comptroller  of  the 
Treasury  refusing  to  approve  the  payment.  A  further  ques- 
tion which  I  shall  not  discuss  is  the  extent  to  which  a  Commis- 
sioner is  bound  by  his  own  or  his  predecessor's  rulings  upon 
claims  for  refund. 

My  purpose  in  referring  to  these  acts  of  the  Treasury  is  to 
show  that  an  interpretation  of  the  Treasury  may  be  merged  in 
an  act  and  that  this  act  may  have  a  legal  force  and  effect  irre- 
spective of  the  correctness  of  the  interpretation  itself. 

(b)  Interpretations  Embodied  in  Acts.  An  interpretation  of 
statute  which  is  embodied  in  an  effective  act  binding  upon  a 
particular  taxpayer  is  also  of  importance  with  respect  to  other 
taxpayers  in  that  it  furnishes  some  indication  as  to  the  manner 
in  which  the  Treasury  will  act  in  a  similar  case,  though,  of 
course,  the  Treasury  is  not  legally  bound  to  follow  its  own  pre- 
cedents. If,  however,  an  interpretation  is  frequently  applied  it 
may  come  to  have  the  effect  of  long-continued  departmental 
practice.  What  that  effect  is,  I  consider  in  connection  with 
interpretative  rulings  of  general  application.  It  may  be  added 
that  the  publication  of  rulings  in  particular  cases  in  the 
Bulletin  of  Income  Tax  Rulings  adds  nothing  to  their  force. 

»  Rev.  Stat.,  Sec.  3229. 

>»  Sweeney  v.  U.  S.  17  Wall.   75. 

»<  Rev.  Stat.,  Sec.  3220. 

"  Ibid.,  Sec.  3226. 


The  Treasury  in  each  such  Bulletin  carefully  warns  taxpayers 
that: 

the  rulings  have  none  of  the  force  or  effect  of  Treasury  Decisions  and 
do  not  commit  the  Department  to  any  interpretation  of  law  which  has 
not  been  formally  approved  and  promulgated  by  the  Secretary  of  the 
Treasury.  Each  ruling  embodies  the  administrative  application  of  the 
law  and  Treasury  Decisions  to  the  entire  state  of  facts  upon  which  a 
particular  case  arises. 

These  rulings  are  published  in  order  that: 

"Taxpayers  and  their  counsel  may  obtain  the  best  available  indica- 
tion of  the  trend  and  tendency  of  official  opinion"  in  the  administration 
of  the  income  tax  statutes. 

2.  Rulings  0}  General  Application.  In  the  absence  of  express 
authority  therefor  undoubtedly  the  Commissioner,  acting  un- 
der the  direction  of  the  Secretary,  could  make  regulations  of 
general  application  with  regard  to  the  manner  of  carrying  on 
the  business  of  his  office.  Such  regulations  are  merely  admin- 
istrative directions  to  a  group  of  subordinates  and  do  not  differ 
in  nature  from  specific  directions  addressed  to  a  single  subor- 
dinate. How  far  such  regulations  would  be  binding  upon  the 
public  need  not  be  considered  since  there  is  in  the  statute  here 
under  consideration  express  authority  for  making  rules  and 
regulations. 

The  Revenue  Act  of  191 8  contains  a  general  provision 
authorizing  the  making  of  "all  needful  rules  and  regulations  for 
the  enforcement  of  the  provisions  of  this  Act."  "  It  also  con- 
tains provisions  authorizing  the  making  of  rules  and  regula- 
tions with  respect  to  specific  subjects.  This  is  true  with  respect 
to  net  losses,^'  depletion,^®  charitable  contributions,^ •  payment 
of  tax  at  the  source,*^  appeals  from  collectors  in  cases  of  under- 
statement in  returns,^  consolidated  returns,^  collection  of 
foreign  items,^  allocation  of  deductions  in  cases  of  Government 

"Sec.  1309. 
"  Sec.  204. 
'•Sec.  214,  234. 
'•Sec.  214. 
"Sec.  217,  221. 
"  Sec.  228. 
**  Sec.  240. 
"Sec.  259. 


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96 


COLUMBIA  INCOME  TAX  LECTURES 


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contracts,*^  corporations  which  are  in  part  personal  service 
corporations,**  rate  of  tax  applicable  to  special  cases,*  taxation 
of  trade  or  business  carried  on  for  part  of  the  taxable  year  by 
an  individual  or  partnership  and  for  part  of  the  year  by  a 
corporation,'^  computation  of  invested  capital  for  pre-war 
year.*®  Regulations  with  regard  to  making  public  tax  returns 
require  the  approval  of  the  President  as  well  as  of  the  Secre- 
tary.*^ There  is  also  a  general  provision  of  law  applicable  to  all 
executive  departments  that  the  head  of  each  department  is 
authorized : 

to  prescribe  regulations  not  inconsistent  with  law  for  the  government 
of  his  Department,  the  conduct  of  its  officers  and  clerks,  the  distribution 
and  performance  of  its  business  and  the  custody,  use,  protection  and 
preservation  of  the  property  appertaining  to  it.w 

(a)  Classification.  Broadly  speaking,  rulings  of  the  Treasury 
Department  of  general  application  may  be  grouped  in  two 
classes — administrative  rulings  and  interpretative  rulings.  An 
administrative  ruling  is  one  which  deals  with  procedure.  It  is 
addressed  to  the  enforcement  of  the  law.  Typical  rulings  of 
this  character  are  the  rulings  with  respect  to  the  forms  upon 
which  returns  shall  be  made,  the  statute  providing  that  per- 
sons liable  to  the  tax  shall  render  such  returns  "as  the  Com- 
missioner with  the  approval  of  the  Secretary  may  from  time  to 
time  prescribe."  ^  An  interpretative  ruling  on  the  other  hand 
is  one  which  purports  to  state  the  meaning  of  the  statute.  An 
example  of  such  a  ruling  is  that  with  respect  to  income  not 
reduced  to  possession — constructive  receipt."  That  regula- 
tion while  recognizing  that  a  taxpayer  may  report  his  income 
on  the  basis  of  actual  receipts  and  disbursements  provides  that : 

Income  which  is  credited  to  the  account  of  or  set  apart  for  a  taxpayer 
and  which  may  be  drawn  upon  by  him  at  any  time  is  subject  to  tax  for 

*<  Sec.  301. 

»  Sec.  303. 

»  Sec.  328. 

*^  Sec.  330. 

*«  Sec.  330.    Cf.  also  Refunds.  Rev.  Stat.,  Sec.  3220. 

**  Sec.  257. 

"  Rev.  Stat.,  Sec.  161. 

"  1918  Law,  Sec.  1305. 

»«  Reg.  45,  Arts.  S3.  54. 


FORCE     OF    TREASURY     INTERPRETATION      97 

the  year  during  which  so  credited  or  set  apart  although  not  then 
actually  reduced  to  possession. 

In  other  words,  the  Treasury  says  that,  as  a  matter  of 
interpretation  of  statute,  income  is  received  when  it  is  credited 
to  the  account  of  or  set  apart  for  a  taxpayer  under  the  circum- 
stances described.  Of  course,  it  is  not  my  purpose  to  discuss 
the  question  as  to  whether  this  regulation  is  good  law.  I  refer 
to  it  merely  as  an  example  of  interpretative  regulations.  There 
may  be,  however,  as  we  shall  see,  rulings  which  do  not  readily 
fall  into  either  of  these  classes. 

(b)  Administrative  Rulings.  The  statutory  provisions  re- 
ferred to  clearly  purport  to  confer  upon  the  Treasury  authority 
to  make  administrative  rulings.  That  Congress  may  delegate 
such  power  is  well  settled  and  such  regulations  have  the  force 
of  law.  In  the  recent  case  of  Maryland  Casualty  Company  v. 
U.  5."  Mr.  Justice  Clark  said: 

It  is  settled  by  many  recent  decisions  of  this  Court  that  a  regulation 
by  a  Department  of  Government  addressed  to  and  reasonably  adapted 
to  the  enforcement  of  an  act  of  Congress,  the  administration  of  which 
is  confided  to  such  Department,  has  the  force  and  effect  of  law  if  it  be 
not  in  conflict  with  express  statutory  provision. 

An  indication  of  the  kind  of  regulations  referred  to  in  this 
statement  may  be  obtained  from  an  examination  of  the  cases 
cited  in  support  of  it.  In  one  of  these  cases  ^  a  regulation  of 
the  Secretary  of  Agriculture  requiring  permits  for  the  use  and 
occupancy  of  public  forest  reserves  was  held  valid,  the  Secre- 
tary being  authorized  by  statute  "to  regulate  the  occupancy 
and  use  and  to  preserve  the  forests  from  destruction." 

In  another  case  ^  a  regulation  of  the  Bureau  of  Indian  Af- 
fairs which  required  subordinates  to  report  violations  of  law 
with  respect  to  traffic  in  intoxicating  liquor  with  the  Indians 
was  held  valid,  one  of  the  important  duties  of  the  Indian  office 
being  the  enforcement  of  such  legislation.  In  the  other  cases 
cited  ^  regulations  prescribed  by  the  Commissioner  of  the  Land 
Office  with  the  approval  of  the  Secretary  of  the  Interior  requir- 

•"  251  U.  S.  342.  p.  349. 

•♦  U.  S.  r.  Grimaud,  220  U.  S.  506. 

•*  U.  S.  V.  Birdsall.  233  U.  S.  223. 

•  U.  S.  ».  SmuU,  236  U.  S.  405;  Morehead  r.  U.  S.,  243  U.  S.  607, 


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COLUMBIA  INCOME  TAX  LECTURES 


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ing  affidavits  from  applicants  for  public  lands  were  held  to 
be  valid  so  that  the  making  of  false  affidavits  constituted  per- 
jury under  a  statute  making  false  swearing  perjury,  "in  any 
case  in  which  a  law  of  the  United  States  authorizes  an  oath 
to  be  administered." 

Similar  decisions  have  been  made  in  internal  revenue  cases. 
Thus  in  In  Re  Kollock  "  the  court  sustained  a  regulation  of 
the  Treasury  prescribing  the  method  of  marking  oleomar- 
garine packages.   The  court  said : 

The  designation  of  the  stamps,  marks  and  brands  is  merely  in  the 
discharge  of  an  administrative  function  and  falls  within  the  numerous 
instances  of  regulations  needful  to  the  operation  of  machinery  of 
particular  laws,  authority  to  make  which  has  always  been  recognized 
as  within  the  competency  of  the  legislative  power  to  confer." 

In  Boske  v.  Comingore  ''  a  regulation  of  the  Treasury  Depart- 
ment, which  declared  that  records  in  the  offices  of  Collectors 
of  Internal  Revenue  were  in  their  custody  and  control  "for 
purposes  relating  to  the  collection  of  the  revenues  of  the 
United  States  only"  and  that  collectors  "have  no  control  of 
them  and  no  discretion  with  regard  to  permitting  the  use  of 
them  for  any  other  purpose"  was  held  to  protect  a  collector 
against  an  order  of  a  state  court  for  the  production  of  such 
records  for  use  as  evidence.  It  will  be  seen  that  the  regula- 
tions considered  in  the  cases  were  procedural.  They  had  to 
do  with  the  method  of  enforcing  the  statute  and  did  not 
affect  substantive  rights. 

The  tests  of  validity  of  an  administrative  regulation  laid 
down  in  Maryland  Casualty  Case*^  are:  (i)  that  it  be  addressed 
to  the  enforcement  of  an  Act  of  Congress,  the  administration 
of  which  is  confided  to  such  department — that  is,  the  officers 
must  have  jurisdiction;  (2)  that  it  be  reasonably  adapted  to 
such  enforcement  and  (3)  that  it  shall  not  be  inconsistent 
with  any  specific  statutory  provision.  This  third  test  means 
not  merely  that  the  executive  department  cannot  make  admin- 

»'  Its  u.  s.  526. 

»*  C/.,  however,  U.  S.  v.  Eaton,  144  U.  S.  677. 

»•  177  U.  S.  459. 

"  Cf.  supra,  p.  97. 


FORCE    OF    TREASURY    INTERPRETATION     99 

istrative  regulations  which  are  contrary  to  statute  but  also 
that  they  cannot  make  regulations  which  add  to  the  statute. 
In  U.  S.  V.  George  *^  this  phase  of  the  rule  was  applied.  A 
statute  which  dealt  with  homestead  claims  for  public  lands 
required  two  credible  witnesses  to  residence  upon  or  cultiva- 
tion of  such  land  by  the  claimant.  A  regulation  of  the  Depart- 
ment of  the  Interior  in  substance  required  three.  The  Court 
held  that  "Congress  had  provided  the  'exact  measure'  of  the 
claimant's  obligation  and  that  the  Department  could  neither 
add  to  nor  detract  from  it."  The  power  of  the  Department  to 
regulate  exists  when  the  statute  is  silent  as  to  method.  It  is 
merely  a  "power  to  fill  in  details." 

The  rule  of  decision  applicable  where  the  validity  of  a  de- 
partmental, administrative  regulation  is  drawn  in  question 
was  stated  in  the  case  of  Boske  v.  Comingore,  already  referred 
to,*^  in  the  following  terms: 

In  determining  whether  the  regulations  promulgated  by  him  [that 
is  the  Secretary  of  the  Treasury]  are  consistent  with  law,  we  must 
apply  the  rule  of  decision  which  controls  when  an  act  of  Congress  is 
assailed  as  not  being  within  the  powers  conferred  upon  it  by  the 
Constitution;  that  is  to  say,  a  regulation  adopted  under  Sec.  i6i  of  the 
Revised  Statutes  (and  the  rule  must  be  equally  applicable  to  other 
statutes  delegating  the  power  to  make  regulations)  should  not  be 
disregarded  or  annulled  unless,  in  the  judgment  of  the  court,  it  is 
plainly  and  palpably  inconsistent  with  law.  Those  who  insist  that  such 
a  regulation  is  invalid  must  make  its  invalidity  so  manifest  that  the 
Court  has  no  choice  except  to  hold  that  the  Secretary  has  exceeded  his 
authority  and  employed  means  that  are  not  at  all  appropriate  to  the 
end  specified  in  the  act  of  Congress. 

Though  the  courts  are  very  careful  to  state  that  the  power 
delegated  to  an  executive  department  to  make  rules  and 
regulations  is  not  a  legislative  power,  the  administrative  rules 
and  regulations  so  made  are  in  many  respects  similar  to 
statutes.  Like  statutes,  for  example,  they  do  not  ordinarily 
have  retroactive  effect.  Furthermore,  they  are  noticed 
judicially  by  the  courts. 

(c)  Interpretative  Rulings.  From  administrative  regulations, 
that  is,  regulations  dealing  with  procedure,  we  pass  to  inter- 

«  228  u.  s.  14. 
*»  Cf.  supra,  p.  98. 


100      COLUMBIA     INCOME     TAX     LECTURES 


FORCE     OF     TREASURY     I  N  T  E  R  P  R  E  T  A  T  I  O  N    lOI 


pretative  regulations,  that  is,  regulations  which  purport  to 
state  the  meaning  of  the  statutes.  The  greater  part  of  the 
Revenue  Act  of  191 8,  as  is  true  of  previous  acts,  is  devoted  to 
describing  in  somewhat  minute  detail  the  method  of  comput- 
ing the  amount  of  tax  due  from  each  taxpayer.  In  this 
computation,  two  factors  are,  of  course,  involved — the 
amount  of  income  and  the  rate  of  tax.  The  rate  of  tax,  in  the 
case  of  the  income  tax,  is  determined  almost  entirely  by  the 
amount  of  income,  while  in  the  case  of  the  excess  profits  tax 
the  rate  itself  depends  upon  two  factors — income  and  invested 
capital.  Taxable  income  and  invested  capital  are  elaborately 
defined  by  the  act.  The  Treasury  in  performing  its  function 
must  determine  the  meaning  of  these  definitions  of  taxable 
income  and  invested  capital  as  well  as  the  meaning  of  the 
rules  laid  down  for  combining  the  several  factors  so  as  to 
determine  the  amount  of  the  tax.  The  question  is  as  to  the 
legal  force  and  effect  of  these  interpretations  by  the  Treasury. 

It  has  already  been  pointed  out  that  specific  acts  may  have 
a  legal  force  and  effect  even  though  based  upon  erroneous 
interpretations  of  statutes.  For  example,  an  assessment  in 
and  of  itself  has  a  certain  legal  force  and  effect.  Here,  however, 
we  consider  the  legal  force  and  effect  of  interpretations  apart 
from  the  effect  of  the  acts  as  such.  As  these  interpretations 
are  ordinarily  embodied  in  rulings  of  general  application  and 
published  as  regulations  or  Treasury  decisions,  the  question  is 
substantially  as  to  the  legal  force  and  effect  of  the  regulations 
and  Treasury  decisions  which  purport  merely  to  interpret  the 
statute.  Many  regulations  are  of  this  character.  I  have 
already  referred  to  the  regulation  with  respect  to  income  not 
reduced  to  possession  as  an  example  of  interpretative  rulings. 
The  status  of  regulations  of  this  character  is  in  the  main  so 
well  settled  that  it  would  be  a  waste  of  time  to  discuss  it  if  it 
were  not  for  the  fact  that  there  seems  to  be  some  misappre- 
hension on  the  subject. 

In  the  first  place  it  is  to  be  noted  that  such  an  interpretative 
regulation  has  not  the  force  of  law.  It  is  not  binding  upon  the 
courts.  It  could  have  the  force  of  law  only  on  one  or  the  other 
of  two  theories,  namely,  that  such  a  regulation  is  made  by  the 


Treasury  in  the  exercise  of  a  delegated  quasi-legislative  power 
and  is  in  its  nature  a  statute  binding  on  courts  as  well  as  on 
administrative  officers,  or  that  such  a  regulation  is  made  by 
the  Treasury  in  the  exercise  of  a  quasi -judicial  power  to  con- 
strue the  statute  without  review  by  the  courts.  Neither  of 
these  theories  is  sound. 

We  have  seen  in  connection  with  administrative  regulations 
that  to  a  limited  extent  Congress  has  delegated  legislative 
power  to  the  Treasury.  The  courts,  however,  are  careful  to 
state  that  the  power  so  delegated  is  not  strictly  legislative  but 
is  a  kind  of  administrative  power.  The  making  of  interpreta- 
tive regulations  is  not  within  the  scope  of  the  congressional 
delegation  of  authority.  A  regulation  which  states  accurately 
the  meaning  of  a  statute  has  no  legal  force.  The  statute  stands 
unaffected  by  the  regulation.  On  the  other  hand,  a  regulation 
which  alters  or  amends  the  statute  is  beyond  the  power  of  the 
Treasury  and  is,  therefore,  void.  Let  me  refer  to  several 
decisions  and  expressions  of  the  court.  The  case  of  Morrill  v, 
Jones  **  arose  under  the  customs  law  which  provided  that : 

Animals,  alive,  specially  imported,  for  breeding  purposes,  from 
beyond  the  seas,  shall  be  admitted  free  [of  duty]  upon  proof  thereof 
satisfactory  to  the  Secretary  of  the  Treasury,  and  under  such  Regula- 
tions as  he  may  prescribe. 

The  Treasury  customs  regulations  provided  that  before  a 
collector  admitted  such  animals  free  he  must,  among  other 
things,  "be  satisfied  that  the  animals  are  of  superior  stock 
adapted  to  improving  the  breed  in  the  United  States."  A  ques- 
tion arose  as  to  the  validity  of  this  regulation  and  the  Court, 
speaking  through  Chief  Justice  Waite,  said: 

The  Secretary  of  the  Treasury  cannot,  by  his  regulations,  alter  or 
amend  a  revenue  law.  All  he  can  do  is  to  regulate  the  mode  of  pro- 
ceeding to  carry  into  effect  what  Congress  has  enacted.  In  the  present 
case,  we  are  entirely  satisfied  the  regulation  acted  upon  by  the  Collector 
was  in  excess  of  the  power  of  the  Secretary.  The  statute  clearly 
includes  animals  of  all  classes.  The  regulation  seeks  to  confine  its 
operation  to  animals  of  "superior  stock."  This  is  manifestly  an  attempt 
to  put  into  the  body  of  the  statute  a  limitation  which  Congress  did  not 
think  it  necessary  to  prescribe.  Congress  was  willing  to  admit,  duty 
free,  all  animals  specially  imported  for  breeding  purposes;  the  Secretary 

«  106  u.  s.  466. 


*■. 


i  t 


1 


102       COLUMBIA     INCOME     TAX     LECTURES 

thought  this  privilege  should  be  confined  to  such  animals  as  were 
adapted  to  the  improvement  of  breeds  already  in  the  United  States. 
In  our  opinion,  the  object  of  the  Secretary  could  only  be  accomplished 
by  an  amendment  of  the  law.  That  is  not  the  office  of  a  treasury 
regulation. 

In  an  earlier  case,  U.S.  v.  200  Barrels  of  Whiskey,^  the  same 
Chief  Justice  said  with  respect  to  an  internal  revenue  regu- 
lation : 

The  regulations  of  the  Department  cannot  have  the  eflfect  of 
amending  the  law.  They  may  aid  in  carrying  the  law  as  it  exists  into 
execution  but  they  cannot  change  its  positive  provisions. 

Similar  decisions  and  expressions  with  respect  to  regulations 
of  executive  departments  are  not  infrequent.  For  example,  in 
U.  S.  V.  U.  S.  Verde  Copper  Company,'^  the  Court  had  under 
consideration  a  regulation  of  the  Interior  Department,  pur- 
porting to  have  been  made  under  express  statutory  authority 
conferred  upon  the  Secretary  of  the  Interior  to  make  rules  and 
regulations,  which  construed  a  statute  permitting  the  use  of 
timber  on  public  lands  for  domestic  purposes  by  defining  the 
word  "domestic."  The  Court  said  ^  with  reference  to  the  regu- 
lation which  defined  this  word : 

If  Rule  7  is  valid,  the  Secretary  of  the  Interior  has  power  to  abridge 
or  enlarge  the  statute  at  will.  If  he  can  define  one  term  he  can  another. 
If  he  can  abridge,  he  can  enlarge.  Such  power  is  not  regulation;  it  is 
legislation.  The  power  of  legislation  was  certainly  not  intended  to  be 
conferred  upon  the  Secretary. 

This  language  in  part  was  quoted  with  approval  in  U.  S.  v. 
George,*"^  and  Morrill  v.  Jones,  U.  S.  v.  U.  S.  Verde  Copper 
Company  and  U.  S.  v.  George  were  cited  with  approval  in  Watte 
V.  Macy.^^  In  U.  S.  v.  Standard  Brewing  Company**  decided 
in  January  of  this  year,  an  indictment  under  the  War-time 
Prohibition  Act,  the  Court,  citing  several  of  the  cases  to  which 
reference  has  been  made,  said^^:  "Administrative  rulings  can- 

**  95  U.  S.  575.  576. 
*>  196  U.  S.  207. 
«»P.  215. 

*'  228  U.  S.  14,  22. 
"  246  U.  S.  606.  609. 

••251  U.  S.  210. 
•»  p.  220. 


FORCE  OF  TREASURY  INTERPRETATION  I03 

not  add  to  the  terms  of  an  act  of  Congress  and  make  conduct 
criminal  which  such  law  leaves  untouched." 

In  the  recent  cases  decided  by  the  Supreme  Court  under  the 
corporation  tax  and  income  tax  statutes,  the  Court  has  not 
found  it  necessary  to  discuss  the  principle  which  we  have  been 
considering.  Some  of  these  cases,  such  as  the  Stock  Dividend 
Case  and  the  Judges*  Salaries  Case,  involved  the  more  funda- 
mental question  as  to  the  validity  of  the  statutory  provisions 
and  it  was  unnecessary  to  consider  regulations  as  to  taxes 
upon  such  dividends  and  judges'  salaries  when  the  statutory 
provisions  purporting  to  tax  such  items  were  invalid.  The 
regulations  fell  with  the  statute.  In  other  cases,  the  Govern- 
ment's contentions  were  not  based  upon  regulations  to  such  an 
extent  that  decisions  against  the  Government  were  rulings  as 
to  the  validity  of  regulations,  though  in  the  first  Stock  Divi- 
dend Case,  Towne  v.  Eisner,^^  it  necessarily  followed  from  the 
decision  of  the  Court — that  stock  dividends  were  not  taxable 
under  the  Revenue  Act  of  191 3 — that  the  Treasury  decision 
to  the  effect  that  they  were,  which  was  issued  before  the  deci- 
sion in  the  case,  but  not  until  after  the  dividend  was  declared 
and  the  stock  issued,  was  invalid.  In  Doyle  v.  Mitchell  Brothers 
Co.,^^  the  Court  stated  that  certain  Treasury  regulations  cor- 
rectly interpreted  the  statute.  But  it  does  not  appear  that  in 
reaching  its  decision  the  Court  gave  any  weight  to  these  regula- 
tions. Neither  in  this  case  nor  in  the  case  of  Hays  v.  Gauley 
Mountain  Coal  Co.,"  both  of  which  held  gains  accruing  before 
the  passage  of  the  taxing  statute  non-taxable,  was  any  ques- 
tion raised  as  to  the  propriety  of  the  method  prescribed  by 
the  regulations  of  apportioning  gains  between  the  period  before 
and  that  after  the  taxing  statute.  In  Goldfield  Consolidated 
Mines  Company  v.  Scott,^  the  government  claimed  a  tax 
greater  in  amount  than  the  tax  ascertained  in  accordance  with 
Treasury  regulations  made  after  the  taxable  year,  but  before 
suit  was  brought,  but  the  Court  held  the  tax  valid  in  spite  of 
the  regulation. 

»»a4s  U.  8.  418. 
"247  U.  S.  179. 
**  247  U.  S.  189. 
•*a47  U.  S.  126. 


«' 


«»1 


■;'t' 


'i> 


104      COLUMBIA     INCOME     TAX     LECTURES 

Though  the  Supreme  Court  has  not  in  the  cases  under  the 
recent  income  tax  statutes  discussed  the  legal  force  and  effect 
of  Treasury  regulations  purporting  to  be  made  under  authority 
of  those  statutes,  the  lower  federal  courts  have  made  some 
statements  upon  the  subject. 

In  Edwards  v,  Keith,^^  the  Circuit  Court  of  Appeals  for  the 
Second  Circuit  spoke  with  reference  to  the  instructions  of  the 
Treasury  printed  upon  the  forms  of  returns  and  presumably 
issued  by  the  Commissioner  with  the  approval  of  the  Secretary, 
to  the  effect  that  professional  men  should  include  in  their  re- 
turns not  only  actual  receipts  but  also  "unpaid  accounts, 
charges  for  services,  or  contingent  income  due  for  that  year  if 
good  and  collectible,"  as  follows: 

^  This  form  may  be  appropriate  enough  to  give  the  Department  full 
mformation  about  an  individual's  earnings  in  any  particular  year  so  as 
to  enable  its  officers  to  check  up  with  accuracy  some  return  of  a  future 
year,  when  his  hope  of  being  paid  what  he  has  earned  finds  fruition. 
But  no  mstructions  of  the  Treasury  Department  can  enlarge  the  scope 
of  this  statute  so  as  to  impose  the  income  tax  upon  unpaid  charges  for 
services  rendered  and  which,  for  aught  anyone  can  tell,  may  never  be 
paid.  .  .  The  phraseology  of  Form  1040  is  somewhat  obscure.  .  . 
but  It  matters  little  what  it  does  mean;  the  statute  and  the  statute 
alone  determines  what  is  income  to  be  taxed. 

In  De  Ganay  v.  Lederer^  the  District  Court  said: 

Great  weight  and  due  deference  is  always  given  to  departmental 
or  other  executive  constructions  of  laws.  The  acceptance  of  such 
constructions  is,  however,  always  limited  by  the  thought  that  the 
imposition  of  a  tax  is  a  legislative  and  not  an  executive  act,  and  we  are 
brought  back  again  to  the  judicial  construction  of  the  statute. 

In  Cryan  v.  Wardellf'  the  Government  claimed  a  tax  from  a 
lessor  upon  the  value  at  the  termination  of  the  lease  of  a 
building  erected  by  the  lessee,  in  accordance  with,  as  the  Court 
(District  Court  for  the  Northern  District  of  California)  says, 
"an  interpretative  ruling  of  the  Treasury  Department  made  for 
the  guidance  of  taxing  officers."  The  Court  held  that  under  the 
terms  of  the  lease  the  building  became  the  property  of  the  lessor 

"231  Fed.  no,  113. 
"  239  Fed.  568. 


67 


263  Fed.  248, 


FORCE     OF    TREASURY     INTERPRETATION   I05 

upon  its  completion  and  was  subject  to  taxation  as  of  that 
date  and  said  that: 

the  regulation  of  the  Treasury  Department  cannot  be  applied  to  such  a 
state  of  facts;  if  so  intended,  it  must  give  way,  as  the  Department  has 
no  power  to  abrogate  a  substantive  rule  of  law. 

In  First  Trust  &  Savings  Bank  v.  Smietanka,^^  the  Circuit 
Court  of  Appeals  for  the  Seventh  Circuit  considered  the 
liability  to  income  tax  under  the  Revenue  Act  of  191 3  of  un- 
distributed income  added  to  the  principal  of  trust  estates.  The 
Court,  after  expressing  approval  of  earlier  regulations,  referred 
to  Treasury  Decision  No.  2231,  issued  July  26,  1915,  which 
stated  that: 

Any  part  of  the  annual  income  of  trust  estates  not  distributed 
becomes  an  entity  and  as  such  liable  for  the  normal  and  additional  tax 
which  must  be  paid  by  the  fiduciary.  When  the  beneficiary  is  not  in 
esse  the  income  of  the  estate  is  retained  by  the  fiduciary  and  such 
income  will  be  taxable  to  the  estate  as  for  an  individual  and  the 
fiduciary  will  pay  the  tax  both  normal  and  additional. 

The  Court  declared  that : 

This  ruling  was  the  cause  of  the  present  and  other  similar  suits.  It 
illustrates  the  not  unnatural  tendency  of  tax  officers  to  increase  the 
revenues  by  implication  and  strained  constructions.  The  Department's 
first  rulings  were  in  harmony  with  the  natural  import  of  the  language 
used  by  Congress:  its  later  ruling  does  more  than  violate  the  canon 
that  doubts  and  ambiguities  are  to  go  against  the  Government,  for  it  is 
based,  not  upon  any  uncertainty  in  the  terms  of  the  act,  but  upon  a 
metamorphosis  of  a  body  of  property  into  a  person,  and  upon  exactions 
contrary  to  the  exemptions  in  the  Act  of  19 13.  .  .  Congress 
recognized  that  such  alterations  and  amendments  were  legislative  and 
passed  the  Amendatory  Act  of  September  8,  1916^  levying  a  tax  upon 
undistributed  income  added  to  the  principal  of  trust  estates. 

The  Court  thus  held  the  Treasury  regulation  invalid  and  the 
tax  assessed  under  it  improperly  assessed. 

The  principle  applicable  to  regulations  of  executive  depart- 
ments generally  is  clearly  applicable  to  regulations  of  the 
Treasury  Department  which  are  merely  interpretative  of  the 
income  tax  statute.  The  statute  in  authorizing  the  making  of 
rules  and  regulations  does  not  delegate  to  the  Treasury  Depart- 
ment a  legislative  or  quasi-legislative  power  to  amend  the 

••  I.  T.  S.  1920,  Sec.  3935-2943* 


A 


i  I 


I 


I06      COLUMBIA     INCOME     TAX     LECTURES 

Statute.    Such  a  regulation  is  not  in  its  nature  a  statute  binding 
upon  the  courts. 

We  now  consider  whether,  though  an  interpretative  regula- 
tion has  not  the  force  of  a  statutory  enactment,  such  a  regula- 
tion may  not  be  a  quasi-judicial  construction  of  the  statute 
which  is  not  subject  to  review  by  the  courts  and  thus  have  the 
force  of  law.  It  is  an  interesting  question  how  far  Congress 
may  confer  upon  an  executive  department  the  power  to  make 
conclusive  adjudications.  In  Bates  &f  Guild  Co.  v.  Paynef^ 
the  majority  of  the  Court  said  that  there  is  a  class  of  cases 
"where  Congress  has  committed  to  the  head  of  a  department 
certain  duties  requiring  the  exercise  of  judgment  and  dis- 
cretion" and  that  in  such  cases  "his  action  thereon  whether 
it  involves  questions  of  law  or  fact  will  not  be  reviewed  by 
the  courts  unless  he  has  exceeded  his  authority  or  this  Court 
should  be  of  opinion  that  his  action  was  clearly  wrong."  The 
rule  was  summarized  as  follows :  •^ 

where  the  decision  of  questions  of  fact  is  committed  by  Congress  to  the 
judgment  and  discretion  of  the  head  of  a  department,  his  decision 
thereon  is  conclusive;  and  that  even  upon  mixed  questions  of  law  and 
fact,  or  of  law  alone,  his  action  will  carry  with  it  a  strong  presumption 
of  Its  correctness,  and  the  courts  will  not  ordinarily  review  it,  although 
they  may  have  the  power,  and  will  occasionally  exercise  the  right  of  so 
doing. 

Tax  cases  are  peculiarly  matters  for  the  executive  branch 
of  the  government  and  there  are  strong  indications  in  the 
decisions  of  the  Supreme  Court  that  the  final  adjudication  of 
tax  liability  may  be  conferred  upon  an  administrative  tribunal 
subject  only  to  review  upon  the  question  of  jurisdiction.  In 
Cheatham  v,  U,  5.,«i  the  Court  held  that  the  provision  that 
suit  in  the  courts  for  refund  of  income  taxes  should  be  brought 
within  six  months  after  appeal  to  the  Commissioner  of  Internal 
Revenue  was  proper  and  said: 

we  regard  this  as  a  condition  on  which  alone  the  Government  consents 
to  litigate  the  lawfulness  of  the  original  tax.  It  is  not  a  hard  condition. 
Few  governments  have  conceded  such  a  right  on  any  condition.  .  .  . 

»» 194  U.  S.  106. 

"P.  no. 

«  92  U.  S.  8s. 


FORCE     OF    TREASURY     INTERPRETATION   I07 

while  in  McMillan  v.  Anderson,^  the  Court  said:  "The  nation 
from  whom  we  inherit  the  phrase  'due  process  of  law'  has 
never  relied  upon  the  courts  of  justice  for  the  collection  of 

her  taxes  .     .     .  "" 

It  is,  however,  unnecessary  to  go  into  this  question  in  the 
present  inquiry  for  there  is  ample  opportunity  for  judicial 
review  of  decisions  of  the  Treasury  Department  as  to  tax 
liability  both  upon  questions  of  law  and  questions  of  fact. 
The  Revised  Statutes  contain  provisions  with  respect  to  suits 
for  the  recovery  of  taxes  from  the  taxpayer  ^  as  well  as  for 
suits  by  the  taxpayer  for  the  refund  of  taxes  erroneously  or 
illegally  assessed  or  collected  ®^  and  the  multitude  of  internal 
revenue  cases  in  the  books  are  instances  of  resort  to  such 
judicial  review.  Since  the  law  is  reviewable  by  the  courts  it 
follows,  of  course,  that  questions  as  to  construction  of  the 
statute  are  open. 

Though  interpretative  rulings  of  the  Treasury  have  not 
the  force  of  law  either  as  quasi-statutes  or  as  conclusive 
adjudications,  they  are  not  without  effect.  These  rulings  at 
least  have  the  force  of  expressions  of  opinion  of  experts  in  that 
particular  branch  of  the  law.  This  is  as  much  as  the  District 
Court,  in  the  case  of  Rech-Marbaker  v.  Ledererf^  concedes 
when  it  says  of  such  a  Treasury  ruling:  "This  executive  con- 
struction, however,  although  informing  and  helpful  is  con- 
trolling only  to  the  extent  to  which  it  is  persuasive."  The 
courts,  to  be  sure,  occasionally  use  expressions  like  that 
already  quoted  from  De  Ganay  v.  Lederer,  to  the  effect  that 
"great  weight  and  due  deference  is  always  given  to  depart- 
mental or  other  executive  constructions  of  laws."  This 
statement,  however,  is  usually  limited  by  the  proviso  that  the 
construction  must  have  been  long  continued.  A  very  late 
statement  of  the  principle  is  found  in  National  Lead  Co.  v. 
U.  5." 

"  95  u.  s.  37. 

•»C/.  also  Murray's  Lessee  ».  Hoboken  Land  &  Improvement  Co.,  18  How.  272. 

•*Sec  3212-3216. 

•»  Sees.  3220.  3224-3227. 

••  263  Fed.  593. 

w  252  U.  S.  140. 


t    J 
.    ) 


[.4 


X- 


I08       COLUMBIA     INCOME     TAX     LECTURES 

The  Court  said : 

From  Edwards  v.  Darby,  12  Wheat.  206,  to  Jacobs  v.  Pritchard,  223  U.  S. 
200,  it  has  been  the  settled  law  that  when  uncertainty  or  ambiguity 
.  .  .  is  found  in  the  statute  great  weight  will  be  given  to  the  contem- 
poraneous construction  by  department  officials,  who  were  called  upon 
to  act  under  the  law  and  to  carry  its  provisions  into  effect — especially 
where  such  construction  has  been  long  continued,  .     .     ." 

In  other  cases,  the  statement  with  regard  to  long  continu- 
ance is  somewhat  more  elaborately  phrased  and  a  long-con- 
tinued executive  construction  which  is  considered  is  said  to 
have  been  "without  question"  ^^  or,  as  another  case  has  it: 

When  there  has  been  a  long  acquiescence  in  a  regulation  and  by  it 
rights  of  parties  for  many  years  have  been  determined  and  adjusted,  it 
is  not  to  be  disregarded  without  the  most  cogent  and  persuasive 
reasons.*' 

Thus  there  is  introduced  an  element  other  than  the  opinion 
of  department  officials,  namely,  the  opinion  of  the  public 
dealing  with  the  Treasury  Department.  In  view  of  the  em- 
phasis placed  by  the  Court  upon  the  element  of  long  continu- 
ance of  a  departmental  construction  it  is  to  be  expected  that 
comparatively  little  weight  will  be  given  as  an  aid  to  construc- 
tion to  an  interpretative  ruling  which  has  not  been  followed 
in  practice  for  a  long  period  of  time.  Of  course,  as  is  pointed 
out  in  numerous  cases,  departmental  interpretations  can  be 
resorted  to  only  when  there  is  ambiguity  or  doubt  as  to  the 
true  meaning  of  the  statute. 

A  further  effect  of  an  interpretative  ruling  may  be  seen  in 
cases  of  re-enactment  of  statutes  considered  by  it.  In  spite 
of  some  indications  to  the  contrary  in  Dollar  Savings  Bank 
V.  U.  5.,'°  the  law  seems  to  be  as  stated  in  the  National  Lead 
Company  Case,  already  referred  to,  that  the  re-enactment  of  a 
statutory  provision  which  has  received  executive  interpre- 
tation 

amounts  to  an  implied  legislative  recognition  and  approval  of  the 
executive  construction  of  the  statute,  for  Congress  is  presumed  to  have 
legislated  with  knowledge  of  such  an  established  usage  of  an  executive 
department  of  the  government. 

w  Cf.  U.  S.  V.  Baruch,  223  U.  S.  191.  200. 
••  Robertson  v.  Downing,  127  U.  S.  607. 
'•  19  Wall  227. 


FORCE  OF  TREASURY  INTERPRETATION  IO9 

Of  course,  interpretative  rulings,  as  a  practical  matter, 
have  considerable  effect  other  than  as  aids  to  construction. 
They  are  instructions  to  subordinates  in  the  Treasury  as  to 
the  method  to  be  used  by  them  in  computing  taxes.  This  is 
their  primary  purpose.  The  method  used  by  the  Treasury 
in  computing  taxes  is  of  vast  importance  to  taxpayers,  for 
only  comparatively  few  of  them  appeal  from  the  decision  of 
the  Treasury  and  the  interpretation  placed  by  the  Treasury 
upon  the  statute  is  conclusive  upon  those  who  do  not  litigate 
or  successfully  save  their  rights  so  as  to  benefit  by  the  litiga- 
tion of  others.  When  a  taxpayer's  liability  has  been  definitely 
fixed  by  the  expiration  of  the  time  for  appeal  from  the  Treasury 
it  is  of  little  moment  to  him  that  this  liability  was  fixed  in 
accordance  with  an  erroneous  interpretation  of  statute. 

It  is  conceivable,  moreover,  that  an  erroneous  interpretative 
regulation  may  lead  to  the  imposition  of  some  administrative 
requirement  which,  while  not  so  unreasonable  when  tested  by  a 
correct  interpretation  of  the  statute  as  to  be  invalid,  would 
not  have  been  made  by  the  Treasury  if  it  had  interpreted  the 
statute  correctly.  This  is  illustrated  in  the  case  of  Edwards  v. 
Keith,  to  which  I  have  already  referred. 

Finally  an  erroneous  interpretative  ruling  may  have, 
indirectly,  legal  as  well  as  practical  effects.  There  can  be  no 
doubt  that  strict  compliance  with  such  a  ruling  will  relieve  a 
taxpayer  from  any  charge  of  fraud  or  bad  faith  though  it  will 
not  relieve  him  from  liability  to  be  taxed  in  accordance  with 
the  correct  interpretation  of  the  statute,  if  such  liability  is 
asserted  by  the  Government  before  the  Statute  of  Limitations 
has  run  in  favor  of  the  taxpayer.  Similarly  such  an  erroneous 
interpretative  ruling  will  relieve  a  subordinate  officer  or  agent 
of  the  Treasury  from  the  charge  of  fraud  or  bad  faith.^' 

An  interpretative  ruling  cannot  in  the  strict  sense  be  retro- 
active. Since  such  a  ruling  has  not  the  effect  of  law  it  is  not 
legally  active  at  all.  Its  indirect  and  practical  effects  may, 
however,  be  retroactive.  Conceivably,  the  effect  of  a  ruling 
as  an  aid  to  construction  may  be  retroactive.  So  far  as  compli- 
ance with  an  erroneous  ruling  shows  good  faith  and  absence  of 

"  Cf.  Tracy  v.  Swartout.  10  Pet.  80, 


I 


I 

If 


I* 


!     i 


/li 


no   COLUMBIA  INCOME  TAX  LECTURES 

fraud  it  cannot,  of  course,  have  a  retroactive  effect.  There  is 
no  such  indication  unless  the  person  whose  action  is  in  question 
knew  of  the  ruling  when  he  acted. 

As  a  matter  of  departmental  administration,  an  interpre- 
tative ruling  may  or  may  not  be  applied  retroactively.    The 
Commissioner  of  Internal  Revenue,  like  other  administrative 
officers,  is  bound  to  enforce  the  law.    Administrative  officers 
are  required  to  use  their  best  judgment  as  to  the  meaning  of  a 
statute.    The  later  judgment  in  the  case  of  a  changed  ruling  is 
presumably  the  better,  else  the  change  would  not  have  been 
made.    It  seems  to  me  clear  that  cases  which  have  not  been 
closed  should   be  disposed  of  in  accordance  with   the  later 
ruling.     Indeed,  theoretically  all  cases  in  which  the  Govern- 
ment is  not  legally  barred  should  be  reopened  and  settled  in 
accordance  with  the  later  and  better  judgment.    As  a  practical, 
administrative  matter,  however,  the  question  as  to  how  far  the 
Treasury  should  go  in  reopening  cases,  which  have  been  closed 
though  the  Government  is  not  legally  barred,  cannot  be  so 
easily  disposed  of.    Clearly  when  a  case  is  reopened  by  the  tax- 
payer it  must  be  disposed  of  on  the  basis  of  the  later  ruling,  but 
I  have  grave  doubt  as  to  whether  ordinarily  it  is  the  duty  of 
the  Treasury  of  its  own  motion  to  reopen  cases  which  have  been 
disposed  of  on  the  basis  of  earlier  rulings.    At  any  rate,  when 
the  administrative  burden  is  so  great  as  it  is  under  the  present 
statute  I  think  that  the  Treasury  should  give  precedence  to 
current  matters.    If  it  does  so,  the  natural  result  will  be  that  it 
will  not  have  the  opportunity  to  reopen  the  earlier  cases  before 
the  Statute  of  Limitations  has  run,  and  this  result  will  not  be  a 
bad  one.    There  are,  however,  extraordinary  cases  to  which  the 
administrative  practice  of  letting  sleeping  dogs  lie,  which  I  have 
suggested,  cannot  properly  be  applied.    Such  a  practice,  for 
example,  is  hardly  applicable  where  decisions  of  the  Supreme 
Court  require  fundamental  changes  in  rulings.    Furthermore, 
the  disposition  of  current  cases  frequently  depends  upon  the 
disposition  of  earlier  ones  and  there  is  something  to  be  said  for 
reviewing  the  entire  series,  as  there  is  where  a  taxpayer  seeks 
to  have  the  cases  reopened  which  are  in  his  favor,  when  there 
are  cases  for  other  years  in  which  the  Government  would  bene- 


FORCE     OF    TREASURY     I  N  T  E  R  P  R  E  T  A  T  I  O  N   III 

fit  by  the  reopening.  The  merit  of  the  legislation  proposed  at 
the  last  session  of  Congress,  and  passed  by  the  House  of  Repre- 
sentatives, with  respect  to  the  retroactive  application  of  regu- 
lations," and  I  think  its  only  merit,  would  be  to  give  to  the 
Treasury  statutory  sanction  for  refraining  from  reopening 
cases  which  have  been  closed.  In  view  of  the  nature  of  inter- 
pretative regulations,  however,  the  proposed  legislation  is 
theoretically  unsound,  and  would  be  practically  objectionable 
to  the  extent  that  it  prevents  the  Treasury  reopening  cases 
upon  motion  of  the  taxpayer  and  the  exceptional  cases  re- 
ferred to. 

In  my  opinion,  the  true  solution  of  the  evil  of  changed  inter- 
pretative regulations  lies  in  an  administrative  development  of 
the  Treasury  to  a  point  at  which  it  will  be  able  to  keep  its  work 
as  nearly  current  as  is  possible  and  in  the  passage  of  a  short 
statute  of  limitations — much  shorter  than  the  present  five- 
year  statute."  If,  however,  the  Government  is  barred  by  a 
short  statute  of  limitations  taxpayers  also  should  be  so  barred 
and  Congress  should  harden  its  heart  against  the  passage  of 
bills  for  the  extension  of  the  period  within  which  suit  can  be 
brought  to  recover  taxes  paid. 

(d)  Regulations  Fixing  Standards.  In  the  preceding  analysis, 
I  have  attempted  to  classify  rulings  as  either  administrative  or 
interpretative.  Some  rulings,  however,  do  not  fall  readily  into 
either  class.  For  example,  what  should  be  said  of  a  ruling  made 
under  the  provision  of  statute  that  if  a  taxpayer  employs  no 
method  of  accounting  or  "if  the  method  employed  does  not 
clearly  reflect  the  income,  the  computation  shall  be  made  .  .  . 
in  such  manner  as  in  the  opinion  of  the  Commissioner  does 
clearly  reflect  the  income."  ^* 

A  ruling  prescribing  a  method  of  accounting  is  not,  like 
a  ruling  prescribing  a  form  of  return,  solely  administrative. 
It  is  something  more  than  procedural  for  it  may  substantially 
affect  the  amount  of  the  tax.  Such  a  ruling  might  conceivably 
be  regarded  as  interpretative  on  the  theory  that  income  is 

"» H.  R.  14198,  sec  S. 

"  C/.  1918  Law,  Sec-  250,  252. 

'♦/Wrf.  Sec  212. 


m 


It 


112       COLUMBIA     INCOME     TAX     LECTURES 

defined  by  statute  and  that  there  can  be  but  one  method  of 
accounting  which  clearly  reflects  it.  This,  however,  is  not  the 
statutory  conception.  The  statute  contemplates  that  income 
may  be  measured  by  actual  receipts  and  disbursements  or  by 
accruals,  and  certainly  there  is  more  than  one  method  of 
accrual  accounting.  Something  is  left  to  the  "opinion  of  the 
Commissioner."  There  is,  therefore,  probably  some  element 
of  quasi-legislation  in  prescribing  a  method  of  accounting  and 
consequently  a  regulation  upon  this  subject  is  more  than 
merely  interpretative.  Such  a  regulation  may,  I  think,  be 
properly  classed  with  those  of  which  the  regulation  sustained 
in  Buttfield  v.  Stranahan,"^^  is  a  type.  In  that  case  the  Court 
sustained  a  statute  which  prohibited  the  importation  of  teas 
inferior  to  the  Government's  standards  of  purity,  quality  and 
fitness  for  consumption  and  authorized  the  Secretary  of  the 
Treasury  to  establish  such  standards.    The  Court  said  :^* 

Congress  legislated  on  the  subject  as  far  as  was  reasonably  practi- 
cable, and  from  the  necessities  of  the  case  was  compelled  to  leave  to 
executive  officials  the  duty  of  bringing  about  the  result  pointed  out  by 
the  statute. 

and  that :  ^^ 

the  sufficiency  of  the  standards  adopted  by  the  Secretary  of  the 
Treasury  was  committed  to  his  judgment  to  be  honestly  exercised. 

In  connection  with  this  case  is  to  be  considered  the  later  case 
under  the  same  statute,  as  amended,  of  Waile  v.  Macey  already 
referred  to,  which  held  that  the  standard  fixed  was  not  a 
standard  of  "purity,  quality  or  fitness  for  consumption, **  and 
that  the  scope  of  the  authority  conferred  by  the  statute  to  fix 
standards  had  been  exceeded. 

Upon  the  authority  of  these  cases  it  may  be  said  that  Con- 
gress, having  under  the  Constitution  the  power  to  impose  a 
tax  on  income,  may  authorize  the  Commissioner  of  Internal 
Revenue  to  prescribe  methods  of  accounting  and  thus  to  an 
extent  fix  a  standard  of  taxable  income,  provided,  of  course, 
that  such  standard  does  not  result  in  the  imposition  of  a  tax 

»  192  U.  S.  470, 

»  p.  496. 
"  P.  497. 


FORCE  OF  TREASURY  INTERPRETATION  II3 

upon  anything  which  is  not  income  under  the  statute  or  the 
Constitution.  In  this  connection,  it  is  interesting  to  note  that 
in  the  Brushaber  Case,''^  the  Supreme  Court  cited  Buttfield  v. 
Stranahan  and  similar  cases  in  support  of  the  proposition  that 
the  Revenue  Act  of  1913  was  not  invalid  because  certain  ad- 
ministrative powers  to  enforce  the  act  were  conferred  by  the 
statute  upon  the  Secretary  of  the  Treasury. 

So  far  as  the  question  as  to  the  retroactivity  of  regulations 
of  this  third  class  is  concerned,  the  rule  would  seem  to  be  the 
same  as  in  the  case  of  purely  administrative  regulations,  but  it 
may  be  that  such  regulations  are  not  retroactive  if  made  at  any 
time  before  computation  of  the  tax. 

Summary.  In  brief,  Treasury  rulings  may  have  effect  in 
and  of  themselves  or  may  be  the  basis  of  acts  which  are  them- 
selves effective.  An  act  even  though  based  on  an  erroneous 
ruling  may  by  lapse  of  time  without  appeal  to  the  courts  or  in 
some  other  way  become  binding  upon  the  Government,  the 
taxpayer,  or  both.  Rulings  are  of  two  principal  classes- 
administrative  rulings  which  deal  with  procedure  and  interpre- 
tative rulings  which  purport  to  state  the  meaning  of  the 
statute  and  to  affect  substantive  rights.  Administrative  rul- 
ings are  made  under  authority  of  a  delegated  quasi-legislative 
power  and,  if  within  the  scope  of  the  delegation,  have  the  effect 
of  law  as  quasi-statutes.  They  are  presumed  to  be  valid.  In- 
terpretative rulings  have  no  effect  as  law  since  they  are  not 
within  the  delegation  of  quasi-legislative  power  and  since  no 
power  of  conclusive  quasi- judicial  construction  is  given  to  the 
Treasury  Department.  Interpretative  rulings  are,  however, 
under  some  conditions  aids  to  the  construction  of  the  statute 
and  have  certain  important  practical  effects.  There  is  proba- 
bly a  third  class  of  rulings  which  are  quasi-legislative  in  char- 
acter made  under  a  delegation  of  power  to  fix  standards  and 
which  to  a  limited  extent  affect  substantive  rights. 

'•  240  u.  s.  I. 


I" 


•  'i 


'  i 


1 


r 


REORGANIZATIONS 


"5 


REORGANIZATIONS  AND  THE  CLOSED 

TRANSACTION 

BY 

Lt.  Col.  Robert  H.  Montgomery,  C.  P.  A. 

No  phase  of  federal  income  tax  law  and  procedure  has  been 
more  perplexing  and  annoying  than  the  determination  of  the 
tax,  if  any,  which  can  or  should  be  imposed  in  respect  of  the 
exchange  of  property  for  other  property,  when  the  property 
received  is  other  than  cash.  Difficulties  do  arise  even  when 
property  is  sold  for  cash,  but  this  discussion  treats  only  of 
transactions  in  which  the  consideration  moving  to  the  owner  of 
property  is  not  cash.  In  other  words,  we  shall  only  discuss 
cases  where  some  question  can  arise  as  to  whether  or  not  a 
certain  transaction  is  a  "closed"  transaction  within  the  meaning 
of  the  federal  income  tax  law. 

Before  quoting  from  the  law  it  is  important  to  consider  the 
regulations  of  the  Treasury,  because  if  the  regulations  were 
clear  and  fairly  dependable  interpretations  of  the  law  it  would 
not  be  necessary  to  do  more  than  state  the  regulations. 

Article  1563  of  Regulations  45  reads,  in  part,  as  follows: 

Exchange  of  Property.  Gain  or  loss  arising  from  the  acquisition  and 
subsequent  disposition  of  property  is  realized  when  as  the  result  of  a 
transaction  between  the  owner  and  another  person  the  property  is 
converted  into  cash  or  into  property  (a)  that  is  essentially  different 
from  the  property  disposed  of  and  (b)  that  has  a  market  value.  In 
other  words,  both  (a)  a  change  in  substance  and  not  merely  in  form, 
and  (b)  a  change  into  the  equivalent  of  cash,  are  required  to  complete 
or  close  a  transaction  from  which  income  may  be  realized.  By  way 
of  illustration,  if  a  man  owning  ten  shares  of  listed  stock  exchanges  his 
stock  certificate  for  a  voting  trust  certificate,  no  income  is  realized, 
because  the  conversion  is  merely  in  form;  or  if  he  exchanges  his  stock 
for  stock  in  a  small,  closely  held  corporation,  no  income  is  realized  if 
the  new  stock  has  no  market  value,  although  the  conversion  is  more 
than  formal;  but  if  he  exchanges  his  stock  for  a  liberty  bond,  income 
may  be  realized,  because  the  conversion  is  into  independent  property 
having  a  market  value. 


No  fault  can  be  found  with  the  foregoing.  It  is  a  reasonable 
interpretation  of  that  part  of  the  Revenue  Act  of  1918  which 
deals  generally  with  the  exchange  of  property  for  other  prop- 
erty. Unfortunately,  however,  the  article  is  not  construed  as  it 
reads  and  there  are  other  regulations  which  conflict  with  Article 
1563.  Furthermore  the  law  itself,  in  the  sections  dealing  with 
reorganizations,  prescribes  a  method  of  determining  profit  or 
loss  which  is  of  questionable  constitutionality  and  which  is 
extremely  difficult  to  apply  and  administer. 

One  of  the  latest  rulings  under  Article  1563  is  the  following:^ 

The  exchange  or  surrender  of  the  stock  of  one  corporation  for  stock 
in  another  corporation,  the  beneficial  interests  remaining  the  same,  is 
an  exchange  of  property  for  other  property  within  the  meaning  of 
Section  202  of  the  Revenue  Act  of  1918,  as  a  result  of  which  the  stock- 
holders sustain  a  deductible  loss  or  realize  profit  subject  to  tax  as  the 
case  may  be. 

The  ruling,  taken  by  itself,  greatly  narrows  Article  1563,  but 
it  is  in  line  with  the  present  procedure  of  revenue  agents,  and 
additional  taxes  are  being  assessed  in  cases  where  the  "prop- 
erty" exchanged  is  the  stock  of  closely  held  corporations  with 
no  real  market  value. 

The  words  "the  beneficial  interests  remaining  the  same"  as 
used  in  the  foregoing  ruling  are  diametrically  opposed  to  the 
spirit  and  the  words  of  the  Supreme  Court  decisions.  If  the 
beneficial  interests  in  so-called  new  property  remain  the  same 
as  in  the  old  property,  how  can  it  be  claimed  that  the  mere  act 
of  transfer,  or  the  exchange  of  one  kind  of  paper  for  another 
kind  of  paper,  results  in  income,  which  may  lawfully  be  taxed 
under  the  Constitution? 

Disposing  of  the  question  of  constitutionality  it  is  inter- 
esting to  note  that  Congress  and  the  taxing  authorities  seem 
to  care  very  little  about  the  limitations  of  the  Sixteenth 
Amendment  to  the  Federal  Constitution  and  it  has  required 
more  than  one  decision  of  the  Supreme  Court  to  make  clear 
what  should  be  obvious,  viz.:  Congress  under  the  Sixteenth 
Amendment  has  the  power  to  tax  income  but  has  no  power  to 
tax  property  without  apportionment.     If  an  exchange  yields 

>  Bulletin,  34-20,  p.  35. 


♦ ' 


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Il6      COLUMBIA     INCOME     TAX     LECTURES 

no  "income"  to  the  taxpaper  no  tax  can  lawfully  be  assessed 
even  though  the  law  or  the  Treasury  calls  it  a  closed  transac- 
tion. 

It  is  possible  that  many  of  the  seeming  difficulties  in  connec- 
tion with  reorganization  and  so-called  closed  transactions 
have  arisen  from  an  attempt  to  understand  and  follow  the 
numerous  regulations  which  have  been  issued,  amended, 
withdrawn  and  superseded.  It  is  suggested  that  in  any  given 
case  the  regulations  be  temporarily  ignored  and  consideration 
be  given  to  the  question  "Does  the  transaction  result  in  the 
receipt  of  income?"  If  it  does  we  can  proceed  to  determine  the 
amount  of  the  income  which  has  been  realized.  If  it  does  not, 
why  bother  with  the  regulations? 

Any  consideration  of  these  questions  requires  a  definition 
of  the  word  "income."  It  is,  however,  unnecessary  to  define 
the  word  "income"  in  any  other  way  than  that  found  in  the 
Supreme  Court  decisions.  If  no  definition  were  found  in 
the  decisions,  we  would  consult  the  dictionaries  and  cite 
common  usage.  The  mere  calling  something  "income"  on  the 
part  of  Congress  oi  the  Treasury  and  then  taxing  it  as  income 
does  not  change  something  else  to  income  if  it  is  not  income 
within  the  meaning  of  the  Sixteenth  Amendment. 

It  may  fairly  be  assumed  that  in  the  case  of  Eisner  v.  Ma- 
comber^  the  Supreme  Court,  having  before  it  a  case  which 
depended  on  an  interpretation  of  the  word  "income,"  gave 
more  careful  consideration  to  its  constitutional  meaning  than 
had  theretofore  been  given,  and  we  may  safely  rely  on  the 
definitions  given  in  the  decision.  The  following  language  was 
used  by  Mr.  Justice  Pitney: 

A  proper  regard  for  its  genesis,  as  well  as  its  ver>'  clear  language, 
requires  also  that  this  Amendment  shall  not  be  extended  by  loose 
construction,  so  as  to  repeal  or  modify,  except  as  applied  to  income, 
those  provisions  of  the  Constitution  that  require  an  apportionment 
according  to  population  for  direct  taxes  upon  property,  real  and 
personal.  This  limitation  still  has  an  appropriate  and  important 
function,  and  is  not  to  be  overridden  by  Congress  or  disregarded  by  the 
courts. 

In  order,  therefore,  that  the  clauses  cited  from  Article  I  of  the 
Constitution  may  have  proper  force  and  effect,  save  only  as  modified 

*  252  U.  S.  189. 


REORGANIZATIONS 


117 


4 


by  the  Amendment,  and  that  the  latter  also  may  have  proper  effect,  it 
becomes  essential  to  distinguish  between  what  is  and  what  is  not 
"income"  as  the  term  is  there  used;  and  to  apply  the  distinction,  as 
cases  arise,  according  to  truth  and  substance,  without  regard  to  form. 
Congress  cannot  by  any  definition  it  may  adopt  conclude  the  matter, 
since  it  cannot  by  legislation  alter  the  Constitution,  from  which  alone 
it  derives  its  power  to  legislate,  and  within  whose  limitations  alone 
that  power  can  be  lawfully  exercised. 

The  fundamental  relation  of  "capital"  to  "income"  has  been  much 
discussed  by  economists,  the  former  being  likened  to  the  tree  or  the 
land,  the  latter  to  the  fruit  or  the  crop;  the  former  depicted  as  a 
reservoir  supplied  from  springs,  the  latter  as  the  outlet  stream,  to  be 
measured  by  its  flow  during  a  period  of  time.  For  the  present  purpose 
we  require  only  a  clear  definition  of  the  term  "income,"  as  used  in 
common  speech,  in  order  to  determine  its  meaning  in  the  Amendment; 
and,  having  formed  also  a  correct  judgment  as  to  the  nature  of  a  stock 
dividend,  we  shall  find  it  easy  to  decide  the  matter  at  issue. 

After  examining  dictionaries  in  common  use  (Bouv.  L.  D.;  Standard 
Diet.;  Century  Diet.),  we  find  little  to  add  to  the  succinct  definition 
adopted  in  two  cases  arising  under  the  Corporation  Tax  Act  of  1909 
{Stratton's  Independence  v.  Howbert,  231  U.  S.  399,  415;  Doyle  v, 
Mitchell  Bros.  Co.,  247  U.S.  179.  185)— "Income  maybe  defined  as 
the  gain  derived  from  capital,  from  labor,  or  from  both  combined," 
provided  it  be  understood  to  include  profit  gained  through  a  sale  or 
conversion  of  capital  assets  to  which  it  was  applied  in  the  Doyle 
case  (pp.  183,  185). 

Brief  as  it  is,  it  indicates  the  characteristic  and  distinguishing 
attribute  of  income  essential  for  a  correct  solution  of  the  present 
controversy.  The  Government,  although  basing  its  argument  upon 
the  definition  as  quoted,  placed  chief  emphasis  upon  the  word  "gain," 
which  was  extended  to  include  a  variety  of  meanings;  while  the 
significance  of  the  next  three  words  was  either  overlooked  or  mis- 
conceived. " Derived -from-capital"— "the  gain-derived-from-capital," 
etc.  Here  we  have  the  essential  matter:  not  a  gain  accruing  to  capital, 
not  a  growth  or  increment  of  value  in  the  investment;  but  a  gain,  a 
profit,  something  of  exchangeable  value  proceeding  from  the  property, 
severed  from  the  capital  however  invested  or  employed,  and  coming 
in,  being  "derived,"  that  is,  received  or  drawn  by  the  recipient  (the 
taxpayer)  for  his  separate  use,  benefit  and  disposal;  that  is  income 
derived  from  property.    Nothing  else  answers  the  description. 

.  .  .  Secondly,  and  more  important  for  present  purposes, 
enrichment  through  increase  in  value  of  capital  investment  is  not 
income  in  any  proper  meaning  of  the  term. 

.  .  .  But  we  regard  the  market  prices  of  the  securities  as  an 
unsafe  criterion  in  an  inquiry  such  as  the  present,  when  the  question 
must  be,  not  what  will  the  thing  sell  for,  but  what  is  it  in  truth  and  in 
essence. 

That  Congress  has  power  to  tax  shareholders  upon  their  property 
interests  in  the  stock  of  corporations  is  beyond  question;  and  that  such 
interests  might  be  valued  in  view  of  the  condition  of  the  company, 
including  its  accumulated  and  undivided  profits,  is  equally  clear.    But 


!l 


Il8       COLUMBIA     INCOME     TAX     LECTURES 

that  this  would  be  taxation  of  property  because  of  ownership,  and  hence 
would  require  apportionment  under  the  provisions  of  the  Constitution, 
is  settled  beyond  peradventure  by  previous  decisions  of  this  Court. 

Taxpayers  are  justified  in  relying  on  the  foregoing  decisions 
when  determining  income  tax  liability.  As  quoted  above, 
income  is  "not  a  growth  or  increment  of  value  in  the  invest- 
ment; but  a  gain  .  .  .  severed  from  .  .  .  and  coming 
in  .  .  .  that  is  income  derived  from  property  .  .  .  more 
important  for  present  purposes,  enrichment  through  increase 
in  value  of  capital  investment  is  not  income  in  any  proper 
meaning  of  the  term." 

Some  of  the  court  decisions  go  so  far  as  to  say  that  gains 
or  income  must  be  realized  in  cash  before  they  can  be  taxed, 
but  it  is  not  necessary  to  go  that  far.  Taxpayers  will  be  con- 
tent if  actual  income  and  not  unrealized  income  is  taxed. 

It  is  evident  that  there  is  a  conflict  between  the  law  and  the 
regulations.  One  must  therefore  discuss  the  subject  on  its 
merits. 

A  discussion  of  exchanges  and  the  closed  transaction  as 
related  to  federal  income  and  profits  taxes  requires  considera- 
tion of  such  points  as  these:  Is  the  present  law  fair?  If  un- 
fair, wherein  should  it  be  changed?  If  fair,  is  it  being  inter- 
preted and  administered  equitably? 

As  will  be  developed  later,  the  present  law  is  the  result  of  a 
last-minute  compromise  so  that  it  is  difficult  to  interpret. 
Many  of  the  suggestions  for  amendments,  however,  arise 
from  improper  administration  rather  than  from  defects  in  the 
law.  It  is  true  that  some  changes  in  the  law  are  desirable,  but 
it  is  equally  true  that  a  more  reasonable  and  logical  adminis- 
tration would  make  the  present  law  less  obnoxious.  I  am  not 
advocating  an  illegal  administration  nor  even  an  administra- 
tion which  resolves  every  doubt  in  favor  of  the  taxpayer.  I 
do  advocate  an  interpretation  of  the  law  which  can  be  applied 
to  actual  income  and  actual  gains.  Deciding  a  doubtful  point 
in  favor  of  a  taxpayer  does  not  foreclose  the  Treasury's  power 
to  collect  a  tax  subsequently,  that  is  as  soon  as  the  realization 
of  income  or  gains  becomes  a  fact  and  enough  cash  or  the 
equivalent  of  cash  is  in  sight  to  pay  the  tax. 


REORGANIZATIONS 


119 


The  case  is  not  the  same  as  where  business  profits  for  a 
particular  year  are  in  question.  The  decisions  in  such  cases 
usually  are  final,  but  in  reorganizations  and  exchanges  the 
so-called  new  property  can  readily  be  followed  and  in  many 
cases  the  government  would  collect  more  tax  if  it  were  to 
accept  the  taxpayers*  contention  that  a  transaction  is  a  con- 
tinuing one  than  if  it  were  to  insist  that  it  is  a  closed  one. 

The  action  of  taxpayers  themselves  has  led  the  Treasury 
to  impose  a  tax  where  none  might  be  imposed  under  ordinary 
circumstances.     "A"  exchanges  property  which  cost  in  1918 
$100,000  for  capital  stock  of  a  par  value  of  $150,000.    If  it  is  a 
close  corporation  it  is  quite  possible  that  it  would  be  held  that 
the  transaction  was  not  a  closed  one  and  no  tax  would  be 
assessed  unless  and  until  the  stock  was  sold.     But  in  most 
cases  "A"  is  the  dominant  factor  in  the  corporation.    As  an 
officer  and  director  he  goes  on  record  that  the  property  is 
actually  worth  $150,000  in  order  that  the  stock  may  be  issued 
fully  paid  and  the  Government  takes  his  word  for  it  and 
imposes  a  tax.     I  do  not  think  that  the  position  of  "A"  is  as 
inconsistent  as  it  sounds.    It  is  not  a  closed  transaction.    No 
income  has  been  realized,  therefore  he  as  an  individual  is  not 
required  to  place  any  value  on  the  stock.    It  merely  takes  the 
place  of  the  property  which  cost  $100,000.    If  the  property  is 
worth  $150,000  the  directors  of  the  corporation,  including 
"A,"  are  within  their  rights  in  issuing  stock  in  exchange  there- 
for having  a  par  value  of  $150,000. 

There  is  little  criticism  when  a  tax  is  imposed  upon  the 
profit  arising  from  a  sale  or  exchange,  the  proceeds  of  which  are 
"the  equivalent  of  cash."  If  a  taxpayer  receives  the  equivalent 
of  cash,  it  is  a  fair  inference  that  he  will  be  able  to  pay  any 
reasonable  amount  of  tax  which  may  be  assessed  in  respect 
thereof.  If  there  is  an  insuperable  difficulty  in  paying  the 
tax,  the  difficulty  probably  arises  from  the  fact  that  the 
transaction  in  question  is  not  a  closed  one.  The  law  itself 
except  in  the  reorganization  section  is  not  defective  because 
nothing  could  be  more  emphatic  than  the  language  of  the 
present  law  which  presupposes  the  equivalent  of  cash  before 
the  tax  can  be  levied. 


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120      COLUMBIA     INCOME     TAX     LECTURES 

The  illustrations  in  the  regulations  would  be  satisfactory 
if  the  Treasury  itself  were  governed  by  them.  Certainly  the 
exchange  of  a  house  for  Liberty  bonds  should  be  regarded  as  a 
closed  transaction.  The  exchange  of  a  house  for  active  stock 
exchange  securities  is  also  a  closed  transaction.  But  the 
exchange  of  a  house  for  another  house  should  not  be  deemed  to 
be  a  closed  transaction.  The  exchange  of  a  cow  which  cost 
$ioo  for  a  horse  worth  $500  closely  approaches  the  stock 
exchange  security  transaction  because  there  is  always  a  market 
for  horses.  It  is  not  believed,  however,  that  many  exchanges 
or  sales  by  farmers  are  returned  as  taxable. 

Much  should  be  left  to  the  good  faith  of  the  taxpayer.  If 
the  property  received  in  exchange  is  the  same  property  in 
another  form  it  should  never  be  considered  to  be  the  equivalent 
of  cash.  The  intention  of  the  parties  to  a  sale  or  exchange  is 
not  difficult  to  ascertain  in  most  cases.  The  exchange  of  a 
house  for  Liberty  bonds  or  stock  exchange  securities  indi- 
cates that  the  owner  is  to  that  extent  getting  out  of  real  estate, 
and  if  he  wishes  to  get  out,  there  is  nothing  unfair  about 
calling  it  a  closed  transaction.  If  one  house  is  exchanged  for 
another  it  is,  or  should  be,  equally  clear  that  the  owner  is 
not  through  with  real  estate;  he  evidences  his  intention  to 
continue  his  investment  therein  and  he  should  not  be  re- 
quired to  account  for  the  exchange  as  if  it  were  a  closed 
transaction. 

The  exchange  of  a  patent  for  stock  of  a  corporation  which 
owns  the  patent  is  not  a  closed  transaction,  and  the  Treasury's 
position  in  so  holding  is  not  logical,  nor  is  it  likely  that  the 
position  will  be  upheld  by  the  courts.  To  impute  a  profit  to 
such  an  exchange  is  to  tax  paper  profits  instead  of  actual 
profits — Bureau-of-Internal-Revenue-income  instead  of  income 
as  defined  by  the  courts. 

The  property  received  must  be  readily  convertible,  on  a 
fair  basis,  into  cash,  or  it  is  not  the  equivalent  of  cash.  The 
courts  have  held  that  the  sale  of  a  small  part  of  the  stock  of  a 
corporation  need  not  be  used  as  a  criterion  of  the  value  of 
the  unsold  stock. 

The   opinion    of    the    United    States    Supreme    Court    in 


REORGANIZATIONS 


121 


Eisner  v.  Macomber »  contains  a  good  test.  In  that  case  the 
property  received  was  additional  common  stock.  An  attempt 
was  made  to  tax  those  who  received  but  who  did  not  sell  their 
stock  and  who  wished  to  hold  it  as  a  continuing  investment. 
The  Court  said,  in  effect,  that  no  tax  should  be  levied,  payable 
to  the  government  in  cash,  unless  there  was  available  cash  to 
pay  the  tax;  that  obviously  the  taxpayer  would  have  to  sell  at 
least  part  of  the  stock  to  pay  the  tax,  and  to  compel  him  to  do 
so  when  he  was  virtually  in  the  same  position  after  as  before 
he  received  the  additional  stock  would  be  inequitable ;  and  that 
no  tax  could  be  assessed  until  the  taxpayer,  by  his  own  act, 
made  a  closed  transaction  out  of  it. 

The  Bureau's  rule  regarding  closed  transactions  has  resulted 
in  precisely  the  same  kind  of  hardship  which  the  United  States 
Supreme  Court  held  was  not  justified.  Inventors  who  have 
owned  nothing  but  stock  in  companies  to  which  the  patents 
were  transferred  and  who  could  not  possibly  sell  their  stock  at 
a  fair  price,  or,  in  some  cases,  at  any  price  at  all,  nevertheless 
have  been  assessed  enormous  taxes  on  alleged  profits  or  income 
which  was  and  could  not  have  been  realized. 

To  sum  up:  a  taxpayer  should  not  be  permitted  to  evade 
the  tax  on  completed  transactions  by  stipulating  that  the 
purchase  price  of  property  disposed  of  should  be  paid  in 
readily  marketable  property,  such  as  stock  exchange  securities, 
and  then  claiming  that  such  securities  were  not  the  equivalent 
of  cash.  But  when  property  received  in  exchange  for  other 
property  cannot  readily  be  converted  into  cash  except  at  a 
sacrifice,  and  the  taxpayer  so  states  under  oath,  and  the 
Treasury  nevertheless  attempts  to  assess  a  tax  thereon,  the 
Treasury  should  be  required  to  prove  that  all  of  the  property 
received  could  have  been  converted  into  cash  at  or  about  the 
time  of  its  receipt  at  a  loss  in  realization  of  not  over  i  per  cent. 
If  the  Bureau  cannot  so  prove,  the  taxpayer  should  be  deemed 
to  have  received  property  not  the  equivalent  of  cash.  If  it 
should  so  prove,  the  taxpayer  should  be  assessed  and  heavily 
penalized  for  having  made  a  false  return. 

*  Cf.  supra,  p.  1 16. 


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122       COLUMBIA     INCOME     TAX     LECTURES 

In  all  cases  where  a  transaction  is  deemed  not  to  be  a 
closed  one,  and  the  new  property  is  considered  as  merely  a 
replacement  of  the  old,  on  final  disposition  of  the  new  property, 
gain  or  loss  will  be  determined  on  the  basis  of  the  original  cost 
of  the  old  property,  or  if  acquired  prior  to  March  i.  191 3,  its 
fair  value  on  that  date. 

If  the  so-called  new  property  produces  more  net  income  than 
the  old,  the  Government  will  receive  additional  taxes  on  such 
increase,  and  no  more  should  be  demanded. 

An  inventor  in  1913  transferred  his  patents  to  a  corporation 
in  exchange  for  its  stock.  A  few  shares  of  the  stock  were  sold 
by  the  corporation  at  a  small  price  to  raise  working  capital. 
It  was  held  that  the  inventor  realized  a  profit  computed  by 
valuing  all  of  his  stock  at  the  same  price  as  that  which  sold. 
The  tax  rate  was  not  high  in  1913,  but  the  inventor  did  not 
sell  any  of  his  own  stock  for  cash  as  he  wished  to  retain  con- 
trol. Even  the  small  tax  would  have  been  a  hardship  as  he 
merely  continued  his  ownership  of  the  patents  in  a  different 
form.  In  191 6  the  stock  of  the  old  company  was  exchanged 
for  stock  of  a  new  company,  the  transaction  being  merely  a 
reorganization.  The  inventor  retained  control.  It  is  pro- 
posed to  tax  him  very  heavily  as  of  191 6  on  an  alleged  profit 
derived  from  the  exchange.  The  inventor  did  not  sell  any 
of  his  own  stock  because  he  would  have  lost  control  if  he  had 
done  so.  Furthermore,  if  the  inventor  had  started  to  sell, 
the  market  for  the  stock  would  have  disappeared. 

In  191 7  the  stock  of  the  second  corporation  was  exchanged 
for  stock  of  another  corporation  and  other  properties  were 
acquired  by  the  new  corporation.  The  inventor  received 
some  cash  but  chiefly  stock  which  he  was  not  permitted 
to  sell  for  six  months  and  at  the  end  of  six  months  he  tried 
to  but  could  not  sell.  It  is  proposed  to  tax  the  inventor  on  a 
large  alleged  profit  as  of  191 7,  although  the  new  company 
has  recently  gone  into  the  hands  of  a  receiver  and  the  stock 
cannot  be  sold  at  any  price.  The  inventor  did  not  report  any 
profit  in  1913,  1916  or  1917.  If  he  had  he  could  not  have 
paid  the  tax  thereon.  If  the  present  proposed  tax  is  upheld 
he  will  be  unable  to  pay  and  he  will  be  ruined.    He  has  no 


REORGANIZATIONS 


123 


recourse  to  the  courts  as  collectors  cannot  be  enjoined  from 
collecting  a  tax  no  matter  how  illegal  or  excessive  the  assess- 
ment may  be.  , .  ,  r. 

The  Income  Tax  Section  of  the  Bureau  of  Internal  Revenue 
holds  that  the  sale  of  a  few  shares  of  stock  is  a  sufficient 
criterion  to  impute  a  market  value  to  an  entire  issue  even 
though  evidence  is  submitted  that  only  a  few  shares  were 
offered  for  sale.  This  position  is  taken  because  it  helps  bolster 
up  the  fiction  of  a  closed  transaction. 

On  the  other  hand,  when  the  sale  of  a  few  shares  of  stock 
at  a  low  price  helps  a  corporation  in  connection  with  the 
capital  stock  tax,  another  section  of  the  Bureau  repudiates 
the  claim  that  such  sales  are  representative.  The  following 
is  an  official  statement  made  in  November,  1920: 

The  value  desired  for  the  purpose  of  this  tax  is  the  net  value  back  of 
the  entire  capital  stock  of  a  going  concern  The  value  reflected  by  the 
sales  of  shares  of  stock  cannot  be  accepted  as  representative  of  the  fair 
value  of  the  total  outstanding  stock,  as  the  sales  reported  are  few  in 
comparison  with  the  total  number  of  shares.  ,         .  j 

The  price  paid  for  the  stock  so  traded  in  on  the  stock  exchange  does 
not  in  all  cases  indicate  the  fair  value  of  the  total  stock,  as  has  been 
clearly  proved  in  the  last  six  months  by  the  wide  fluctuations  in  stocks 
commonly  known  as  standard  investments.  The  investors  or  pur- 
chasers on  the  stock  exchange  buy  the  stocks  by  reason  of  their 
desirability  from  a  speculative  view  as  a  commodity  and  are  not 
governed  by  the  value  back  of  the  stocks  or  their  earning  capacities. 

In  order  to  collect  a  tax  on  closed  transactions  and  a  tax 
on  the  fair  value  of  capital  stock  an  old  rule  is  adopted,  viz: 
"Heads  I  win,  tails  you  lose."  A  business  house  which  tried 
to  adopt  this  rule  would  be  considered  to  be  dishonest. 

In  1916  The  General  Motors  Co.  of  New  Jersey  caused  to 
be  organized  The  General  Motors  Co.  of  Delaware.  To  the 
latter  were  transferred  en  bloc  all  the  assets  of  the  New  Jersey 
company.  Five  shares  of  Delaware  Company  common  stock 
were  exchanged  for  one  share  of  New  Jersey  company  common 
stock.  With  the  exception  of  a  few  cents  differential  in  the 
preferred  stock  transfer,  the  holder  of  the  Delaware  stock 
had  nothing  new  but  a  different  piece  of  paper.  The  assets 
and  earnings  were  the  same.  In  fact,  many  stockholders 
did  not  make  the  exchange  in  1916  as  one  share  of  the  old 


124       COLUMBIA     INCOME     TAX     LECTURES 

common  continued  to  sell  for  the  same  price  as  five  shares 
of  the  new.  Any  stockholder  who  desired  to  retain  his  in- 
vestment in  The  General  Motors  Co.  intact  could  not  have 
done  so  if  he  had  reported  the  transaction  as  a  closed  one, 
unless  he  could  have  paid  the  resulting  tax  from  other  sources 
of  revenue.  The  majority  owner  of  the  stock  would  have 
lost  control  if  he  had  been  taxed  on  the  apparent  profit, 
and  if  he  had  tried  to  sell,  in  order  to  get  the  money  to  pay 
the  tax  on  his  profit,  the  market  would  have  broken  and  there 
would  have  been  no  profit.  The  Treasury's  position  leads 
to  a  rediictio  ad  ahsurdum  in  this,  as  in  some  other  matters. 

The  case  is  analogous  to  the  stock  dividend  decision  wherein 
it  is  held  that  to  require  a  majority  holder  of  a  corporation, 
which  makes  a  change  in  its  form  but  none  in  substance,  to 
lose  his  control  although  he  desires  to  continue  his  interest 
in  the  same  property,  would  be  an  unnecessary  hardship, 
and  one  for  which  no  authority  exists  under  the  Sixteenth 
Amendment. 

The  only  logical  solution  of  the  present  mess  is  for  the 
Treasury  to  rule  that  when  property  is  paid  in  for  stock  of  a 
corporation,  or  stock  was  exchanged  for  stock  prior  to  191 8, 
and  the  new  stock  represented  the  same  assets  as  the  old 
property  or  stock,  the  exchange  was  a  continuing  and  not  a 
closed  transaction. 

There  is  unanimity  of  opinion  in  one  respect,  viz,  the  term 
"equivalent  of  cash"  has  not  yet  been  satisfactorily  defined  by 
the  Treasury.  Frequently  the  intention  of  the  framers  of  a 
law  is  helpful  when  ambiguity  exists.  The  Congressional 
Record  sheds  some  light  on  this  point.  From  the  questions 
and  answers  regarding  section  202  it  is  obvious  that  during 
the  debate  in  the  House  of  Representatives,  Mr.  Kitchin 
who  introduced  the  bill,  and  others  who  were  most  prominently 
identified  with  it,  were  not  in  much  doubt.  The  following 
question  and  answer  ^  should  be  considered  as  authoritative 
because  no  dissent  from  the  answer  was  made : 

Mr.  Hardy.  If  "A"  and  "B,"  owning  two  tracts  of  land,  exchange 
those  tracts  without  any  money  being  paid,  although  each  one  of 

*  Congressional  Record,  September  i6.  1918,  pp.  10351-10352. 


REORGANIZATIONS 


125 


4 


them  has  enhanced  in  value,  is  there  any  tax  on  that  exchange? 

Mr  FoRDNEY.  No.  They  have  received  nothmg.  They  have  had 
no  income.  You  do  not  have  an  income  until  you  convert  the  property 
into  money.  I  may  own  a  piece  of  land  and  exchange  with  you  for 
another  piece  of  land  today  worth  twice  what  the  property  cost  me 
when  I  gave  it  to  you,  but  there  is  no  income,  because  I  have  not 
converted  it  into  money. 

In  view  of  the  foregoing,  existing  regulations  do  not  appear 
to  be  fair  interpretations  of  the  law. 

It  may  fairly  be  said  that  the  tendency  of  the  courts  is  to 
permit   taxpayers   to  withhold   the   return  of   income   until 
there  is  a  definite  realization  in  money,  or  in  some  thing  so 
near  to  what  most  people  look  upon  as  money  that  no  tax- 
payer will  be  embarrassed  in  finding  the  funds  to  pay  the 
tax.    In  other  words  we  can  count  upon  a  liberal  interpreta- 
tion of  the  terms  "equivalent  of  cash"  and  "fair  market  value." 
In  reaching  this  conclusion  I  do  not  rely  upon  the  decisions 
of  the  courts  in  the  cases  of  Maryland  Casualty  Co.  v.  U.  5.* 
and  Doyle  v.  Mitchell  Bros.  Co.*     In  those  cases  the  courts 
intimated  that  cash  receipts  rather  than  accruals  must  be 
considered   in    arriving  at   taxable   income,   but  both   cases 
were   brought    under    the   federal  corporation   tax   of    1909 
which  was  an  excise  and  not  an  income  tax.    As  an  excise  tax 
the  Attorney  General  consistently  and  quite  properly  took 
the  position   in   his  official  opinions  that   taxpayers  would 
have  to  make  up  their  returns  on  a  cash  basis.    But  in  prac- 
tice the  Treasury  never  attempted  to  enforce  a  cash  basis. 
Blanks  were  sent  out  which  called  for  a  return  of  net  income 
on  an  accrual  basis.    As  this  was  the  only  sensible  thing  to 
do  and  as  taxpayers  desired  to  prepare  their  returns  on  an 
accrual   basis   practically   no   one   questioned   the   irregular 
action  of  the  Treasury.    But  when  a  taxpayer  questioned  the 
authority  of  the  Treasury  and  invoked  the  law,  the  courts 
naturally  gave  consideration  to  its  very  clear  intent,  and  as 
the  intent  of  the  law  was  clearly  contrary  to  an  accrual  basis 
the  cash  basis  appeared  to  be  and  was  sustained. 
I  read  in  most  of  the  decisions  of  the  courts  under  the  1913 

»  52  Ct.  Cl.  201. 
•  247  U.  S.  179. 


I 


•  ■ , 


i! 


,!■■' 


126       COLUMBIA     INCOME     TAX     LECTURES 

and  subsequent  laws  definitions  of  income  which  agree  with 
the  understanding  of  most  taxpayers.  The  chief  trouble  is 
with  the  regulations  and  the  practice  of  the  Treasury. 

In  such  cases  as  the  instalment  business  the  accrual  method 
may  be  ignored  (even  though  perhaps  all  instalment  houses 
keep  their  books  under  the  accrual  method),  and  a  cash  basis, 
for  which  I  find  no  warrant  in  the  law,  may  be  substituted. 

In  the  case  of  inventors  and  others  who  exchange  property 
for  shares  of  stock,  or  investors  who  exchange  stock  of  a 
corporation  incorporated  in  one  state  for  stock  of  the  same 
corporation — (with  the  same  assets  and  the  same  liabilities) 
incorporated  in  another  state,  the  accrual  method  is  imposed. 
In  the  former  case  taxpayers  who  have  no  special  claim  for 
relief  are  tremendously  benefited,  while  in  the  latter  case 
taxpayers  are  actually  threatened  with   financial  ruin. 

I  repeat  that  the  solution  is  not  a  difficult  one.  All  that 
IS  required  is  a  reasonable  interpretation  of  the  terms  "equiva- 
lent of  cash"  and  "fair  market  value.** 

Prior  to  the  enactment  of  the  1918  law  there  was  no  dis- 
tinction in  the  law  itself  between  the  exchange  of  various 
classes  of  property.  The  law  broadly  taxed  the  gain  or  in- 
come "derived  from  the  sale  or  other  disposition  of  property." 
There  must  have  been  a  gain  "derived"  before  the  tax  could 
be  assessed.  Obviously  the  law  could  not  tax  anything  except 
income,  so  that  the  word  "derived"  could  be  no  broader  than 
the  word  "income." 

In  order  to  limit  or  prevent  the  taxation  of  unrealized  gains 
there  was  a  strong  trend  in  Congress,  at  the  time  the  191 8 
law  was  being  written,  towards  stating  in  specific  words  that 
no  tax  would  be  imposed  when  property  was  exchanged  for 

stock. 

The  Senate  draft  of  the  reorganization  section  of  the  191 8 

law  was  as  follows: 

.  .  .  or  when  a  person  or  persons  owning  property  receive  in  exchange 
for  such  property  stock  of  a  corporation  formed  to  take  over  such 
property,  no  gain  or  loss  shall  be  deemed  to  occur  from  the  exchange, 
and  the  new  stock  or  securities  received  shall  be  treated  as  taking  the 
place  of  the  stock,  securities,  or  property  exchanged. 


REORGANIZATIONS 


127 


It  was  felt,  however,  that  the  Senate  draft  was  too  liberal 
and  that  ways  might  be  devised  to  escape  tax  in  cases  where 
income  was  cleariy  realized.  Instead  of  defining  what  was 
meant,  Congress  passed  the  following: 

When  Par  Value  of  New  Securities  Is  Greater. 

Law.  Section  202.  (b)  .  .  .  When  in  the  case  of  any  such 
reorganization,  merger  or  consolidation  the  aggregate  par  or  face  value 
of  the  new  stock  or  securities  received  is  in  excess  of  the  aggregate  par 
or  face  value  of  the  stock  or  securities  exchanged,  a  like  amount  in  par 
or  face  value  of  the  new  stock  or  securities  received  shall  be  treated  as 
taking  the  place  of  the  stock  or  securities  exchanged,  and  the  amount 
of  the  excess  in  par  or  face  value  shall  be  treated  as  a  gain  to  the  extent 
that  the  fair  market  value  of  the  new  stock  or  securities  is  greater  than 
the  cost  (or  if  acquired  prior  to  March  i,  1913.  the  fair  market  value 
as  of  that  date)  of  the  stock  or  securities  exchanged. 

The  foregoing  section  of  the  law  is  difficult  of  interpretation. 
In  this  case  the  conflicring  intenrions  of  the  legislators  pro- 
duced an  unsatisfactory  result. 

It  will  be  noted  that  the  new  matter  (which  was  inserted 
by  the  conferees  of  the  Senate  and  House)  attempts,  as  a 
maximum,  to  impose  a  tax  upon  the  excess  of  the  par  value 
of  the  new  securities  over  the  aggregate  par  of  the  old.  Under 
the  Senate  bill  no  tax  at  all  would  have  been  imposed  upon 
former  owners  who  retained  stock  in  corporations  formed  to 
take  over  their  property.  The  compromise  was  not  intended 
unduly  to  penalize  such  persons,  but  its  exact  import  will 
probably  never  be  known. 

The  part  of  the  section  dealing  with  the  excess  of  par  value 
has  been  interpreted  to  mean  that  in  no  case  shall  the  gain 
upon  which  the  former  owner  is  to  be  taxed  exceed  the  amount 
by  which  the  aggregate  new  par  exceeds  the  aggregate  old 
par.  If  stock  having  par  of  $10,000  (the  fair  market  value  of 
which  is  $1,000,000)  is  exchanged  for  stock  having  new  par 
of  $100,000  (fair  market  value  of  $1,000,000),  the  gain  is 
deemed  to  be  $90,000  and  not  $990,000.  But  if  stock  having 
par  of  $100,000  (the  fair  market  value  of  which  on  March  i, 
1913,  was  $150,000)  is  exchanged  for  new  stock  having  par 
of  $200,000  (the  fair  market  value  being  $200,000)  the  gain 
is  deemed  to  be  $50,000  and  not  $100,000. 


41 


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If'. 


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128       COLUMBIA     INCOME     TAX     LECTURES 

The  regulation  confirming  the  foregoing  statement  follows: 

Regulation.  If  in  the  case  of  any  reorganization,  merger  or  con- 
solidation the  aggregate  par  or  face  value  of  the  new  stock  or  securities 
received  is  in  excess  of  the  aggregate  par  or  face  value  of  the  stock  and 
securities  exchanged,  income  will  be  realized  from  the  transaction  by 
the  recipients  of  the  new  stock  or  securities  to  an  amount  limited  by 
(a)  the  excess  of  the  par  or  face  value  of  the  new  stock  or  securities 
over  the  par  or  face  value  of  the  old  and  (6)  the  excess  of  the  fair 
market  value  of  the  new  stock  or  securities  over  the  cost  or  fair  market 
value  as  of  March  i,  1913,  of  the  old.  In  other  words,  the  taxable 
profit  will  be  (a)  or  (6),  whichever  is  less.  Upon  a  subsequent  sale  of 
the  new  stock  or  securities  their  cost  to  the  taxpayer  will  be  the  cost 
or  fair  market  value  as  of  March  i,  1913,  of  the  old  stock  and  securities, 
plus  the  profit  taxed  on  the  exchange.    (Regulations  45,  Art.  1569.). 

When  Stock  Received  Has  No  Greater  Par  Value.  Uninten- 
tionally perhaps  the  way  was  opened  to  enable  taxpayers  to 
take  advantage  of  the  plan  embodied  in  the  Senate  draft  in  all 
cases  when  the  par  value  of  the  new  securities  in  a  re- 
organization was  not  material,  or,  what  is  more  probable,  the 
framers  of  the  bill  were  all  familiar  with  the  trend  towards 
no-par-value  securities  and  it  was  expected  that  most  re- 
organizations would  not  be  taxable.  Without  the  slightest 
possibility  of  precipitating  a  tax,  any  reorganization  can  go 
through  without  making  anyone  liable  to  the  tax  if  care  is 
taken  to  keep  down  the  par  value  of  the  new  securities. 
The  law  thus  places  a  premium  upon  those  reorganizations, 
mergers  and  consolidations  which  otherwise  might  be  held 
to  be  closed  transactions,  but  in  which  payment  is  made  for 
securities  on  a  basis  of  the  same  or  smaller  par  value.  In 
such  cases  no  return  whatever  is  required  even  though  there 
be  an  actual  or  market  value  of  the  new  shares  which  is 
several  times  the  par  value. 

When  a  taxpayer  exchanges  1,006  shares  of  stock  of  a  par 
value  of  $100  for  100,000  shares  of  $1  par  value  in  a  new 
corporation,  no  gain  can  be  deemed  to  occur  even  though  the 
cost  or  value  March  i,  191 3,  of  the  old  stock  was  $100  per 
share  and  the  fair  market  value  of  the  new  stock  is  $10  per 
share,  thus  indicating  an  apparent  profit  of  $900,000.  The 
apparent  profit  cannot  be  taxed,  as  the  language  and  intent 
of  the  law  are  clear  and  not  ambiguous. 


REORGANIZATIONS 


129 


It  is  not  a  question  of  why  Congress  did  not  tax  such 
transactions:  the  fact  is  that  it  did  not  do  so  and  did  not 
intend  to  do  so.  Logically  it  may  be  inferred  that  there  could 
not  possibly  have  been  any  intention  to  tax  a  similar  trans- 
action wherein  the  exchange  was  for  100,000  shares  of  no- 
par-value  stock  which  at  the  time  of  receipt  might  have  an 
apparent  market  value  of  $10  or  more. 

When  No-Par-Value  Stock  Is  Received.    As  stated  elsewhere 
it  was  originally  intended,  in  writing,  the  1918  revenue  law, 
that  when  capital  stock  or  property  was  exchanged  for  capital 
stock,  and  the  new  stock  represented  the  same,  or  substantially, 
the  same  assets,  and  was  issued  to  the  former  owners,  there 
would  be  no  taxable  profit  or  deductible  loss  unless  the  new 
stock  were  disposed  of  for  cash  or  the  equivalent  of  cash. 
From  the  conference  compromise  there  emerged  that  weird 
Section  202.     It  was  thought  for  some  time  that  the  chief 
ambiguity  in  the  section  was  in  the  second  paragraph  of  Sub- 
Section  2  (b)  wherein  new  stock  of  greater  par  value  is  referred 
to,  and  that  the  first  paragraph  (which  in  effect  says  that 
there  shall  be  no  tax  when  new  stock  is  of  no  greater  par  value 
than  the  old  securities  for  which  it  is  exchanged)  was  clear 

and  workable. 

In  the  first  edition  of  Regulations  45  which  was  issued  withm 
a  few  weeks  after  the  law  was  passed  there  was  no  specific 
reference  in  Article  1567  to  no  par  value  stock,  although  for 
a  number  of  years,  and  in  many  states,  the  practice  of  issuing 
stock  without  par  value  has  met  with  increasing  favor. 

Between  the  original  edition  of  the  regulations  and  the 
edition  of  April  17,  1919.  there  was  time  to  ascertain  the  inten- 
tion of  Congress  and  to  interpret  property  the  meaning  of  the 
section.  Article  1567  was  considerably  modified  and  reduced. 
The  principal  change  which  has  a  direct  bearing  on  the  subject 
under  discussion  occurs  in  the  last  sentence:  "If  the  stock  so 
received  has  no  nominal  or  par  value  the  limitation  on  aggre- 
gate par  value  is  inapplicable."  This  was  intended  and 
accepted  as  a  reasonable  interpretation  of  the  law. 

But  on  June  20,  1919,  there  was  issued  a  Treasury  decision 
which  completely  changed  Article  1567.    The  last  sentence  of 


I 

i 


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130      COLUMBIA     INCOME     TAX     LECTURES 

Article  1567,35  it  appeared  in  the  April  17  edition,  was  omitted 
and  in  substitution  therefor  the  following  was  added : 

Regulation.  .  .  So-called  "no-par-value  stock"  issued  under  a 
statute  or  statutes  which  require  the  corporation  to  fix  in  a  certificate 
or  on  its  books  of  account  or  otherwise  an  amount  of  capital  or  an 
amount  of  stock  issued  which  may  not  be  impaired  by  the  distribution 
of  dividends,  will  for  the  purpose  of  this  section  be  deemed  to  have 
a  par  value  representing  an  aliquot  part  of  such  amount,  proper  account 
being  taken  of  any  preferred  stock  issued  with  a  preference  as  to 
principal.  In  the  case  (if  any)  in  which  no  such  amount  of  capital  or 
issued  stock  is  so  required,  "no-par- value  stock"  received  in  exchange 
will  be  regarded  for  purposes  of  this  section  as  having  in  fact  no  par 
or  face  value,  and  consequently  as  having  "no  greater  aggregate  par  or 
face  value"  than  the  stock  or  securities  exchanged  therefore.  (T.D. 
2870,  June  20,  1919). 

On  September  26,  191 9,  another  decision  was  issued  '  and 
Article  1567  was  further  amended,  but  the  amendment  did 
not  make  any  change  at  all  in  the  part  of  the  article  under 
discussion. 

Today  no  one  who  tries  to  comply  with  the  Treasury  regula- 
tions knows  how  no-par- value  stock  should  be  dealt  with. 

The  reason  no  one  knows  is  that  the  obvious  intention  of  the 
law  is  disregarded  and  an  attempt  is  being  made  to  impute  to 
no-par-value  stock,  market  value  when  it  has  no  market  value 
and  also  par  value  when  it  has  no  par.  When  there  is  a  doubt 
about  the  meaning  of  a  word,  common  usage  is  supposed  to 
control.  But  in  determining  whether  or  not  stock  has  par 
value  we  are  told  to  search  the  statutes  of  many  different 
states,  so  that  what  is  called  no-par-value  stock  in  one  state 
might  be  deemed  to  have  a  par  value  of  $19.89  if  a  corporation 
should  reincorporate  in  another  state,  and  happened  to  have 
that  amount  of  net  worth  back  of  each  share. 

It  is  absurd  to  think  that  one  taxpayer  who  receives  shares 
of  no-par- value  Delaware  stock,  pays  no  tax,  whereas  another 
taxpayer  in  precisely  the  same  position  as  to  cost  of  original 
property,  present  worth,  etc.,  and  who  received  no-par- value 
Pennsylvania  stock  may  have  an  enormous  tax  imposed,  even 
though  in  both  cases  there  is  no  intention  whatever  on  the 
part  of  either  taxpayer  to  dispose  of  his  property. 

»  T.  D.  2924. 


REORGANIZATIONS 


131 


Space  will  not  permit  a  full  discussion  of  this  point.  The 
law  does  not  appear  to  be  ambiguous.    It  reads  as  follows : 

Law.  Section  202  (6)  .  .  •  but  when  in  connection  with  the 
reorganization,  merger,  or  consolidation  of  a  corporation  a  person 
receives  in  place  of  stock  or  securities  owned  by  him  new  stock  or 
securities  of  no  greater  aggregate  par  or  face  value  no  gam  or  loss 
!hall  be  deemed  to  occur  from  the  exchange,  and  the  new  stock  or 
^curities  received  shall  be  treated  as  taking  the  place  of  the  stock, 
securities,  or  property  exchanged. 

It  is  not  pleasant  to  differ  so  radically  from  the  Treasury 
but  it  seems  probable  that  the  courts  will  not  find  the  law 
difficult  to  interpret.  An  amendment  to  the  law  in  the  future 
will  not  cure  its  defects,  if  any.  I  think  that  the  cure  will 
come  from  a  forced  reversal  of  the  Treasury's  position  rather 
than  from  an  amendment. 

The  regulations  do  not,  and  probably  cannot,  define  with 
any  degree  of  finality  what  is  and  what  is  not  a  reorganization. 
When  physical  property  is  exchanged  for  shares  of  stock  or 
shares  of  stock  are  exchanged  for  other  shares  of  stock,  the 
transaction  usually  is  referred  to  as  a  reorganization.    When 
the  shares  received  in  exchange  cover  the  same,  or  substan- 
tially the  same,  property  as  was  covered  by  the  property  or 
shares  exchanged  there  is  a  continuing  interest  which  should 
not  be  taxed.    It  may  be,  however,  that  the  new  shares  repre- 
sent the  ownership  of  radically  different  assets  so  that  the- 
old  owner,  instead  of  continuing  his  interest,  in  fact  sells  out 
and  acquires  an  interest  in  a  different  concern.    In  the  latter 
case  the  transaction  should  be  referred  to  as  a  sale  and  not  as 
a  reorganization.     If  the  shares  received  are  those  of  a  cor- 
poration for  whose  securities  there  is  a  broad  market,  and  the 
securities  received  can  readily  be  disposed  of  without  affecting 
the  market,  I  see  no  objection  to  holding  that  the  equivalent 
of  cash  has  been  received. 

Another  class  of  transactions  is  found  where  the  purchase 
price  or  consideration  arising  from  the  sale  or  exchange  of 
property  is  payable  over  a  period  of  years.  Usually  in  the  case 
of  these  instalment  sales  the  deferred  payments  are  definite 
in  amount,  payable  in  cash  at  fixed  times  and  represented  by 
promissory  notes.    The  promissory  notes  in  turn  are  secured 


it 


132       COLUMBIA     INCOME     TAX     LECTURES 

by  collateral  and  by  Hens,  if  they  are  in  the  form  of  chattel 
mortgages.    The  Treasury  regulations  are  in  part  as  follows: 

Art.  42.  Sale  of  Personal  Property  on  Instalment  Plan. — Dealers  in 
personal  property  ordinarily  sell  either  for  cash,  or  on  the  personal 
credit  of  the  buyer,  or  on  the  instalment  plan.  Occasionally  a  fourth 
type  of  sale  is  met  with,  in  which  the  buyer  makes  an  initial  payment  of 
such  a  substantial  nature  (for  example,  a  payment  of  more  than 
25  per  cent.)  that  the  sale,  though  involving  deferred  payments,  is  not 
one  on  the  instalment  plan.  In  sales  on  personal  credit,  and  in  the 
substantial  payment  type  just  mentioned,  obligations  of  purchasers 
are  to  be  regarded  as  the  equivalent  of  cash,  but  a  different  rule  applies 
to  sales  on  the  instalment  plan.  Dealers  in  personal  property  who 
sell  on  the  instalment  plan  usually  adopt  one  of  four  ways  of  protecting 
themselves  in  case  of  default:  (a)  through  an  agreement  that  title  is 
to  remain  in  the  seller  until  the  buyer  has  completely  performed  his 
part  of  the  transaction;  (b)  by  a  form  of  contract  in  which  title  is 
conveyed  to  the  purchaser  immediately,  but  subject  to  a  lien  for  the 
unpaid  portion  of  the  purchase  price;  (c)  by  a  present  transfer  of  title 
to  the  purchaser,  who  at  the  same  time  executes  a  reconveyance  in  the 
form  of  a  chattel  mortgage  to  the  seller;  or  (d)  by  conveyance  to  a 
trustee  pending  performance  of  the  contract  and  subject  to  its  pro- 
visions. The  general  purpose  and  effect  being  the  same  in  all  of  these 
plans,  it  is  desirable  that  a  uniformly  applicable  rule  be  established. 
The  rule  prescribed  is  that  in  the  sale  or  contract  for  sale  of  personal 
property  on  the  instalment  plan,  whether  or  not  title  remains  in  the 
vendor  until  the  property  is  fully  paid  for,  the  income  to  be  returned  by 
the  vendor  will  be  that  proportion  of  each  instalment  payment  which 
the  gross  profit  to  be  realized  when  the  property  is  paid  for  bears  to  the 
gross  contract  price.  Such  income  may  be  ascertained  by  taking  as 
profit  that  proportion  of  the  total  cash  collections  received  in  the 
taxable  year  from  instalment  sales,  (such  collections  being  allocated 
to  the  year  against  the  sales  of  which  they  apply)  which  the  annual 
gross  profit  to  be  realized  on  the  total  instalment  sales  made  during 
each  year  bears  to  the  gross  contract  price  of  all  such  sales  made  during 
that  respective  year.  In  any  case  where  the  gross  profit  to  be  realized 
on  a  sale  of  contract  for  sale  of  personal  property  has  been  reported  as 
income  for  the  year  in  which  the  transaction  occurred,  and  a  change  is 
made  to  the  instalment  plan  of  computing  net  income,  no  part  of  any 
instalment  payment  received  subsequently  to  the  change,  representing 
income  previously  reported  on  account  of  such  transaction,  should  be 
refX)rted  as  income  for  the  year  in  which  the  instalment  payment 
is  received ;  the  intent  and  purpose  of  this  provision  is  that  where  the 
entire  profit  fiom  instalment  sales  has  been  included  in  gross  income 
for  the  year  in  which  the  sale  was  made,  no  part  of  the  instalment 
payments  received  subsequently  on  account  of  such  previous  sales 
shall  again  be  subject  to  tax  for  the  year  or  years  in  which  received. 
Where  the  taxpayer  makes  a  change  to  this  method  of  computing  net 
income  his  balance  sheet  should  be  adjusted  conformably.  If  for  any 
reason  the  vendee  defaults  in  any  of  his  instalment  payments  and  the 


REORGANIZATIONS 


133 


vendor  repossesses  the  property,  the  entire  amount  received  on  mstal- 
ment  payments,  less  the  profit  already  returned,  will  be  income  of  the 
vendor  for  the  year  in  which  the  property  was  repossessed,  and  the 
property  repossessed  must  be  included  in  the  inventory  at  its  original 
cost  to  himself,  less  proper  allowance  for  damage  and  use,  if  any.  If 
the  vendor  chooses  as  a  matter  of  consistent  practice  to  treat  the 
obligations  of  purchasers  as  the  equivalent  of  cash,  such  a  course  is 
permissible.     (T.  D.  3082,  October  20,  1920.) 

From  the  point  of  view  of  a  closed  transaction  the  usual 
instalment  sale  fulfills  all  of  the  requirements  except  that  of 
payment  in  full  in  cash.  Most  concerns  which  sell  on  the 
instalment  plan  formerly  kept  their  books  on  the  accrual  plan 
and  treated  all  sales  as  closed  transactions.  To  cover  the 
unusual  losses  and  expenses  of  realization,  reserves  for  bad 
debts  were  set  up  so  that  the  accounts  for  each  year  accurately 
reflected  the  net  profit  for  such  year.  The  only  essential 
diflferences  between  the  ordinary  concern  selling  on  short-time 
credit  and  the  one  selling  on  long-time  credit  are  that  the  latter 
requires  a  somewhat  higher  reserve  for  bad  debts,  say  five 
per  cent,  instead  of  one  per  cent.,  and  more  working  capital. 

These  two  items,  however,  justify  no  special  consideration 
under  any  of  the  federal  tax  laws,  but  for  some  unexplained 
reason  instalment  houses  have  received  extraordinary  treat- 
ment from  the  Bureau  of  Internal  Revenue.  It  is  held  that  the 
sale  of  a  piano  for  $200  payable  in  20  monthly  instalments  of 
$10  each  (each  instalment  represented  by  a  negotiable  promis- 
sory note)  is  not  a  closed  transaction.  The  possibility  of  loss 
is  negligible  as  a  substantial  initial  cash  payment  is  required 
and  a  chattel  mortgage  is  taken,  under  which  the  piano  may 
be  seized  if  the  payments  are  not  met.  Yet  the  Treasury  holds 
that  an  inventor  who  exchanges  his  patent  for  the  entire 
stock  of  corporation,  only  a  few  shares  of  which  are  sold,  is 
taxable  on  the  exchange  as  if  it  were  a  closed  transaction. 
Probably  not  once  in  a  hundred  times  are  all  of  his  shares 
salable  at  any  price  and  not  five  times  in  a  hundred  is  there  a 
strong  probability  that  in  subsequent  years  there  will  be  an 
opportunity  to  dispose  of  the  shares  for  cash.  But  the  instal- 
ment concern  is  permitted  to  call  its  sale  of  a  piano  an  open. 


i 


134       COLUMBIA     INCOME     TAX     LECTURES 


REORGANIZATIONS 


135 


untaxable  transaction,  with  no  tax  to  be  assessed  unless  and 
until  actual  cash  is  received. 

It  is  well  known  that  there  is  a  good  market  for  the  promis- 
sory notes  of  instalment  houses,  although  the  rate  of  discount 
is  higher  than  on  short  time  paper.  It  is  equally  well  known 
that  there  usually  is  no  fair  market  whatever  for  the  stock  of 
closely-  held  corporations. 

The  most  recent  ruling  in  respect  of  instalment  sales  at- 
tempts to  justify  the  present  position  of  the  Treasury.  If  the 
principle  so  clearly  stated  could  be  depended  upon  to  be  the 
consistent  attitude  of  the  Treasury  there  would  not  be  so 
much  uncertainty  about  closed  transactions.  Office  Decision 
715,  appearing  in  official  Bulletin  of  Income  Tax  Rulings,  45-20, 
is  as  follows: 

In  the  case  of  sales  of  personal  property  where  substantial  initial 
payments  are  made  (more  than  25  per  cent,  of  sale  price),  Article  42 
of  Regulations  45  provides  that  obligations  of  the  purchasers  are  to  be 
regarded  as  the  equivalent  of  cash.  It  is  recognized  that  in  many  sales 
of  this  type  the  obligations  of  purchasers,  even  though  represented 
by  notes  or  other  paper  in  negotiable  form,  cannot  be  discounted  or 
otherwise  converted  into  cash  without  material  loss  because  of  lack  of 
credit  on  the  part  of  the  buyer  and  the  nature  of  the  property  covered 
by  such  contracts.  The  obligations  of  the  purchasers  in  those  cases  can 
scarcely  be  considered  the  equivalent  of  cash  in  any  sense,  and  it  is  not 
contemplated  by  the  regulations  that  such  obligations  are  required  to 
be  so  treated.  On  the  other  hand,  the  profits  from  such  sales  may  be 
computed  in  accordance  with  the  rule  prescribed  in  cases  of  the  sale  or 
contract  for  sale  of  personal  property  on  the  instalment  plan,  provided, 
of  course,  the  taxpayer  chooses  to  do  so  as  a  matter  of  consistent 
practice,  and  provided  a  statement  is  attached  to  the  taxpayer's  return 
disclosing  the  fact  and  showing  conclusively  that  the  obligations  of  the 
purchasers  are  not  the  equivalent  of  cash. 

Under  the  foregoing  it  is  apparent  that  a  showing  by  a 
taxpayer  that  he  found  promissory  notes  hard  to  discount 
would  be  accepted  as  sufficient  to  postpone  the  assessment  of 
any  tax  until  the  notes  were  paid  in  cash. 

In  these  days  when  tax  rates  fluctuate  violently  from  year 
to  year,  uniformity  of  treatment  with  respect  to  the  taxation 
of  realizations  is  highly  important.  The  owners  of  two  pieces 
of  property  appreciating  in  an  identical  manner  over  a  period 
of  years  may  have  to  pay  radically  different  taxes,  depending 


upon  the  particular  years  when  realizations  chance  to  occur. 
This  difference  may  develop  to  such  serious  proportions  as  to 
justify  an  attempt  to  devise  some  method  of  inventory  for 
such  property  which  would  result  in  an  annual  tax  on  the 
appreciation  of  each  person's  property  at  the  same  rates.  Or  it 
may  lead  to  the  system  of  taxation  of  gains  which  was  adopted 
regarding  dividends  received  in  191 7,  viz.,  the  apportion- 
ment of  part  of  the  gain  to  previous  years  and  the  application 
of  the  tax  rates  in  force  in  those  years. 

It  may  be  necessary  to  apportion  the  gain  ratably  over  the 
previous  years  and  thus  work  certain  inequities,  but  in  most 
cases  the  prorating  system  would  spread  the  surtax  and  thus 
remove  the  chief  criticism  of  a  tax  law  which  imposes  in  one 
year  a  graduated  tax  upon  a  gain  which  may  have  been  accru- 
ing since  191 3.  While  the  present  situation  continues,  it 
would  seem  wise  to  avoid  as  many  opportunities  for  injustice 
as  possible  by  making  sure  that  the  tax  is  levied  only  in  cases 
which  are  undeniably  realizations. 

It  might  be  urged  that  if  a  taxpayer  were  permitted  to 
continue  to  exchange  or  trade  securities  without  being  required 
to  report  such  transactions  for  income  tax,  he  might  in  the 
course  of  time  run  up  a  "shoe-string"  to  a  million  dollars  with- 
out having  paid  a  cent  of  tax  thereon.  This  is,  of  course,  true, 
but  such  a  person  would  be  in  no  more  favorable  a  position 
than  the  person  whose  property  appreciates  to  a  like  degree 
without  being  exchanged  back  and  forth  from  hand  to  hand. 
The  truth  is  that  there  is  no  logical  stopping  point  between  the 
policy  of  taxing  no  capital  gains  at  all  and  the  policy  of  taxing 
everyone's  capital  gains  periodically  upon  the  basis  of  an 
inventory.  The  present  law  essays  a  compromise  and  attempts 
to  tax  gains  when  the  property  exchanged  has  a  "fair  market 
value."  I  contend  that  this  value  should  be  something  more 
definite  than  a  guess  or  even  a  value  imputed  from  an  occa- 
sional market  quotation  for  similar  property.  The  tax  should 
rest  upon  a  substantial  foundation. 

It  is  not  suggested  that  the  Treasury  should  have  the  power 
to  enforce  the  inventory  method  as  it  would  result  in  a  tax  on 
unrealized  appreciation,  but  if  a  taxpayer  desires  voluntarily 


,« 


I 


136      COLUMBIA     INCOME     TAX     LECTURES 


to  adopt  such  a  method  there  could  be  no  valid  reason  against 
it. 

At  present  the  realization  of  a  substantial  profit  from  the 
sale  of  property  which  has  been  held  for  a  period  of  years 
carries  with  it  an  almost  prohibitive  tax,  and  it  is  argued  that 
that  many  business  transactions,  ordinarily  desirable  for  the 
proper  conduct  of  business,  are  on  this  account  not  consum- 
mated. 

Probably  the  best  plan  would  be  to  permit  the  prorating  of 
the  profit  over  the  years  during  which  the  property  was  held. 
This  plan  has  many  supporters,  including  the  Secretary  of  the 
Treasury,  and  it  is  probable  that  the  law  will  be  amended  to 
give  effect  thereto.  It  must  be  remembered,  however,  that 
the  rate  of  tax  and  the  spreading  of  the  tax  over  a  period  of 
years  have  no  direct  relation  to  the  question  "when  is  a  trans- 
action a  closed  one?" 


LOSS  AS  A  FACTOR  IN  THE  DETERMINATION 

OF  INCOME 

Depreciation,  Obsolescence,  Amortization 
AND  Losses  Due  to  Casualties  or  Theft 

BY 

George  E.  Holmes 

Our  present  federal  income  tax  system  is  devised  accord- 
ing to  a  concept  of  income  different  from  that  underlying  any 
f.^rmer  system  in  this  country  and,  perhaps,  different  from 
that  in  the  minds  of  the  legislators  of  any  other  country— 
certainly  different  from  that  according  to  which  the  British 
system  of  income  taxation  was  built  up. 

Income  may  be  regarded  as  the  fruit  of  a  tree  called  capi- 
tal.^    The  fruit  would  be  interest,  dividends,  rents,  royalties, 
trading  profits,   et  cetera.     This  appears  to  have  been  our 
notion  of  income  in  the  taxing  statutes  of  the  Civil  War  period 
and  it  seems  to  be  the  same  in  Great  Britain.    In  our  present 
system,  comprising  all  the  acts  passed  since  the  Sixteenth 
Amendment  to  the  Constitution,  the  notion  is  that  not  only 
should  the  taxpayer  be  taxed  on  the  annual  fruit  which  his 
tree  of  capital  bears,  but  also  upon  the  growth  of  the  tree 
itself — the  enlargement  of  the  trunk  and  branches,  and  the 
new  branches  which  have  sprouted  during  the  year.     One 
difficulty  we  have  is  to  measure  this  growth  of  capital;  it  may 
be  so  imperceptible  or  so  indefinite  as  to  be  incapable  of  meas- 
urement annually,  and,  therefore,  the  statute  provides  that 
the  increase  in  capital  shall  not  be  taxed  until  the  increase  can 
be  definitely  measured  in  terms  of  money,  by  reason  of  a  sale 
or  exchange. 

>  Thi8  picturesque  anaology  was  used  by  the  Supreme  Court  of  Georgia  in  Waring  t. 
Savannah,  60  Ga.  100.     Cf.  Supra,  p.  10  et  seg. 


1% 


138      COLUMBIA     INCOME     TAX     LECTURES 

Stated  in  another  way,  our  federal  tax  is  imposed  on  tax- 
payers in  accordance  with  their  ability  to  pay;  and  this  in 
turn  is  measured  by  the  taxpayer's  annual  increase  in  net 
worth,  from  all  sources,  so  far  as  it  can  be  measured  in  terms 
of  money. 

Since  we  take  into  consideration  the  growth  of  the  tree,  as 
well  as  the  fruit  thereof,  in  calculating  net  income,  we  must 
also  carefully  consider  the  damage  done  to  the  tree  during  the 
year,  for  it  would  not  be  feasible  to  go  on  taxing  the  new 
growth  and  ignoring  the  damage  to  the  old  growth.  On  the 
other  hand,  if  we  ignored  the  growth  of  the  tree  and  taxed  only 
the  annual  fruit  which  it  yielded,  we  would  find  it  unnecessary 
to  pay  so  much  attention  to  the  damage  suffered  by  the  tree. 
This  illustrates  one  great  difference  between  our  tax  system 
and  the  British  system.  We  tax  capital  gains  and  allow  for 
capital  losses;  the  British  do  not  tax  capital  gains  and 
generally  speaking,  ignore  capital  losses. 

Capital  losses,  other  than  those  incurred  in  sales,  may  be 
divided  into  two  general  classes:  (a)  those  which  take  place 
completely  within  the  tax  year  and  can  be  measured  at  the 
time  they  take  place,  such  as  losses  arising  from  fire  or  other 
casualties  or  from  theft,  and  (b)  the  more  gradual  and  less 
perceptible  losses  which  take  place  through  depreciation  or 
obsolescence  of  an  asset  used  in  producing  income.  There  is  a 
third  and  most  extraordinary  loss,  provision  for  which  is 
made  in  the  Revenue  Act  of  1918,  generally  called  the  amorti- 
zation of  war  facilities.  These  various  losses  will  be  discussed 
in  the  order  of  their  general  interest  to  taxpayers. 

Depreciation 

In  its  broad  sense  depreciation  means,  by  derivation  and 
common  usage,  a  fall  in  value;  a  reduction  of  worth.*  But 
the  word  is  not  used  in  this  broad  sense  when  we  refer  to 
depreciation  in  connection  with  income  taxes.  In  fact,  only 
one  of  the  statutes  in  our  present  system  of  income  taxation, 

•  New  York  Life  Ins.  Co.  v.  Anderson.  263  Fed.  527. 


LOSSES 


139 


i,  e.y  those  statutes  passed  in  1913  and  thereafter,  uses  the  term 
"depreciation." 

The  Act  of  August  6,  1909,  which  was  not  a  true  income 
tax  law,'  did  provide  for  "a  reasonable  allowance  for  deprecia- 
tion of  property,"  and  under  that  law  it  was  permitted  to  take 
into  consideration  loss  in  market  value.  Corporations  were 
permitted  to  mark  their  investments  down — or  up — according 
to  market  prices,  and  to  reflect  the  result  in  the  calculation  of 
that  statutory  net  income  by  which  the  tax  was  measured. 

That,  however,  is  not  permitted  under  the  income  tax 
statutes  passed  since  the  adoption  of  the  Sixteenth  Amend- 
ment. The  allowance  for  depreciation  is  clearly  defined  as 
"a  reasonable  allowance  for  exhaustion,  wear  and  tear  of 
property"  or,  in  one  provision  only,  "a  reasonable  allowance 
for  depreciation  by  use,  wear  and  tear  of  property." 

Kind  of  Property  Subject  to  Depreciation.    The  property  on 
which  depreciation  may  be  claimed  must  be  used  or  employed 
in  the  business  or  trade  of  the  taxpayer.    Trade  or  business 
in  this  sense  may  be  broadly  interpreted  to  mean  any  activity 
from  which  taxable  income  arises.     It  excludes  a  taxpayer's 
residence,  because  that  is  not  employed  in  his  business  or 
trade,  and  any  loss  thereon  through  depreciation  is  considered 
a  personal  or  living  expense.    But  it  would  include  residential 
property  from  which  a  taxpayer  derives  income,  for  then  the 
building  is  considered  to  be  employed  in  trade  or  business.    It 
would  not  include  an  idle  building  merely  held  for  speculation 
or   investment;    any   loss   through   deterioration   would    be 
reflected  in  the  selling  price.    It  does  not  include  land  itself,  for 
that  is  not  susceptible  of  wear  and  tear  or  exhaustion.     In 
certain  cases,  however,  depreciation  may  be  claimed  with 
respect  to  the  capital  used  to  prepare  land  for  certain  commer- 
cial purposes.     For  example,   if   an  orchard  is  planted  for 
commercial  exploitation  it  may  happen  that  a  large  investment 
is  necessary  in  order  to  plant  the  trees,  and  these  trees  may 
have  a  definite  life  beyond  which  there  will  be  no  income 
yield.    In  such  cases  the  original  cost  of  planting  and  the  cost 

•  This  Act  imposed  an  excise  tax  on  corporations  for  the  privilege  of  doing  business,  the 
tax  being  measured  by  "net  income"  as  defined  in  the  statute. 


140      COLUMBIA     INCOME     TAX     LECTURES 

of  development  up  to  the  point  of  fruit-bearing  may  be 
capitalized  and  the  capital  investment  depreciated  over  the 
income-producing  years  of  the  trees.  Ordinarily,  perhaps,  the 
cost  of  planting  and  caretaking  is  charged  to  expense  in  the 
years  in  which  the  expenditures  are  made,  in  which  case  no 
depreciation  is  chargeable.  Again,  in  sugar  plantations 
great  expense  may  be  incurred  in  preparing  the  land  and 
setting  the  plants.  Notwithstanding  a  consistent  replanting 
to  take  the  place  of  dead  plants,  the  whole  plantation  must  be 
re-worked  and  replanted  after  a  certain  number  of  years.  The 
cost  of  this  work  may  be  capitalized  and  depreciation  taken 
over  the  fruitful  life  of  the  crop. 

With  respect  to  mineral-bearing  lands  and  timber,  special 
rules  are  formulated  under  that  provision  of  the  law  which 
allows  depletion,  a  subject  to  be  treated  elsewhere  and  which, 
therefore,  will  not  be  dwelt  upon  here. 

Any  property  used  in  a  taxpayer's  business  may  be  depre- 
ciated, even  clothes,  such  as  the  costumes  of  an  actor,  but 
nothing  used  for  the  taxpayer's  pleasure  or  personal  comfort 
is  a  subject  of  depreciation.  An  automobile  chiefly  used  for 
pleasure  is  excluded,  but  one  used  for  business  is  included.  In 
case  of  doubt  the  taxpayer  must  show  a  reasonable  need  for 
the  property  in  his  trade  or  business,  otherwise  the  presumption 
is  against  the  allowance  of  the  claim  for  depreciation. 

Depreciation  does  not  apply  to  things  bought  by  the  tax- 
payer for  resale,  but  is  intended  to  apply  to  things  used  by 
him  to  produce  income  and  which  wear  out  or  become  ex- 
hausted in  the  course  of  such  use.  Therefore,  inventories  of 
stock  in  trade  cannot  be  depreciated.  Any  deterioration 
therein  may  be  allowed  for  only  in  accordance  with  the  rules 
relating  to  inventories. 

Machinery,  buildings  and  similar  tangible  property  are 
most  generally  thought  of  in  connection  with  depreciation. 
Depreciation  by  wear  and  tear  is  most  marked  in  machinery 
and,  it  seems,  the  theory  of  allowing  depreciation  first  grew 
up  around  the  problem  of  how  properly  to  prepare  for  the 
purchase  of  a  new  machine  when  the  old  was  worn  out.  Under 
our  present  law,  depreciation  is  not  limited  to  the  exhaustion, 


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wear  and  tear  of  physical  property  only;  it  includes  intangible 
property  as  well.  The  intangible  property,  however,  must  be 
such  as  has  a  use  in  the  trade  or  business  for  a  definitely 
limited  period.  Patents,  copyrights,  licenses  and  franchises 
may  be  good  examples.  Goodwill,  trade-marks  and  brands 
are  not  considered  subject  to  exhaustion  or  wear  and  tear, 
and  there  is  no  general  way  to  measure  definitely  the  time 
when  they  will  cease  to  be  useful  in  the  business.  Therefore, 
depreciation  cannot  apply,  although  obsolescence  may,  under 
exceptional  circumstances.  The  test  as  to  whether  or  not 
an  intangible  asset  can  be  depreciated  for  purpose  of  the  tax 
may  often  be  found  in  the  question  "Can  the  useful  life  of 
this  asset  be  accurately  and  definitely  determined?"  If  not, 
there  is  no  measure  by  which  an  allowance  can  be  ascertained, 
and  although  the  asset  may  gradually  disappear,  accounting 
therefor  must  await  some  occasion  when  definite  determina- 
tion, by  way  of  sale  or  otherwise,  fixes  the  amount  of  the 
taxpayer's  loss. 

The  Valine  Which  May  Be  Provided  for  by  Depreciation. 
Having  regarded  the  various  kinds  of  property  which  depreci- 
ate for  income  tax  purposes,  we  will  consider  the  amount 
which  in  the  aggregate  may  be  deducted  as  depreciation  with 
respect  to  a  particular  asset. 

The  underlying  theory  of  depreciation  is  that  the  taxpayer 
shall  be  allowed  to  set  aside  such  sums  annually  as  in  the 
aggregate  will  equal  his  capital  investment  in  the  property 
and  that  such  sums  shall  be  free  from  tax,  for  to  tax  them 
would  be  to  tax  his  capital.  Receipts  must  necessarily  be 
divided  into  two  parts — one,  the  return  of  capital,  and  the 
other,  profit  or  income.  We  have  this  problem  in  all  cases  of 
receipts,  except  purely  compensation  for  personal  services. 
On  sales  we  deduct  the  cost  of  the  goods  sold.  When  we  have 
thereby  reached  a  taxpayer's  gross  income,  we  deduct  his 
legitimate  business  expenses.  The  deduction  for  depreciation 
is  one  of  these  and  is  simply  spreading  over  a  number  of  years 
the  cost  of  property  which  disappears  in  use  while  creating 
goods  or  services  that  produce  income.  If  a  taxpayer  accounted 
for  net  income  only  once  in  a  lifetime,  and  sold  all  his  assets 


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142       COLUMBIA     INCOME     TAX     LECTURES 

for  cash  before  so  doing,  we  would  not  have  any  problem  of 
depreciation,  for  the  final  sale  would  determine  with  absolute 
accuracy  what  his  profit  had  been,  assuming  a  correct  account 
of  actual  receipts  and  disbursements  had  been  kept.  But  we 
have  an  accounting  for  tax  purposes  each  year,  and  it  is  in 
the  interest  of  the  accuracy  of  this  yearly  accounting  that  we 
calculate  the  annual  depreciation. 

The  capital  of  a  taxpaper  represented  by  any  particular 
asset  may  be  one  of  two  things:  (a)  the  value  of  that  asset 
on  February  28,  1913,  or  (b)  its  cost  if  acquired  after  that 
date.  The  former  is  an  artificial  measure  of  capital  due  to 
the  limitation  on  the  power  of  Congress  to  tax  income  which 
accrued  prior  to  the  adoption  of  the  Sixteenth  Amendment 
to  the  Constitution;  the  latter  is  the  natural  capital  invest- 
ment. 

To  ascertain  the  value  on  March  i,  1913,  is  often  a  difficult 
problem.  It  is  a  question  of  fact  and  subject  to  all  the  un- 
certainty of  such  a  question.  In  the  absence  of  proof  to  the 
contrary,  the  value  on  that  date  will  be  presumed  to  be  the 
original  cost  less  depreciation.  But  if  it  can  be  shown  that 
the  particular  asset  in  fact  increased  in  value  the  taxpayer 
is  entitled  to  take  the  fair  market  value  on  March  i,  1913,  as 
the  basis  of  depreciation  thereafter.  Conversely,  if  it  appears 
that  the  value  of  the  property  was  less  than  cost  minus  depreci- 
ation, the  lower  value  must  be  adopted.  As  a  general  rule, 
no  change  in  value  is  asserted  by  the  taxpayer,  but  occasion- 
ally, and  especially  in  the  case  of  patents,  the  fair  market 
value  on  March  i,  1913,  can  be  shown  to  have  been  much 
greater  than  the  cost. 

The  cost  of  property  is  generally  a  fact  simple  of  ascertain- 
ment. It  includes  the  amount  paid  for  the  property  originally 
plus  any  subsequent  expenditures  for  improvements,  addi- 
tions and  betterments  and  carrying  charges,  provided  the  cost 
thereof  was  not  deductible  as  an  expense  in  the  year  when 
the  expenditure  was  made.  The  capital  invested  in  an  asset, 
which  would  normally  be  subject  to  depreciation,  may  be 
reduced  by  loss  or  damage  to  the  property  or  by  sale  of  a 
part  thereof,  in  which  cases  the  depreciation  basis  must  be 


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adjusted.  If  it  is  borne  in  mind  that  by  depreciation  allow- 
ances the  taxpayer  is  presumed  to  have  returned  to  him  his 
capital  outlay  in  a  series  of  fair  annual  allowances  which  will 
amount  to  the  total  capital  outlay  at  or  about  the  time  the 
property  is  worn  out  or  exhausted,  many  of  the  problems 
become  easy  of  solution. 

One  difficulty  in  determining  cost  arises  where  a  lump  sum 
is  paid  for  an  aggregate  of  depreciable  and  non-depreciable 
property,  as  for  instance,  where  land  and  buildings  together 
are  purchased.  In  such  cases  the  respective  values  of  the 
depreciable  and  non-depreciable  property  must  be  determined 
in  order  to  find  the  proper  basis  for  depreciation.  Such  segre- 
gation is  a  question  of  fact  and  no  general  rules  can  be  laid 
down. 

Another  difficulty  arises  where  the  consideration  paid  for 
the  property  is  in  some  other  form  than  cash.  In  the  case 
where  the  transfer  of  property  is  made  to  a  corporation  the 
consideration  is  frequently  either  stock  of  the  corporation  or 
its  bonds.  In  such  cases  the  "cost"  to  the  corporation  which 
may  be  depreciated  is  the  fair  cash  value  of  the  stock  or 
other  securities  issued  therefor,  provided  such  stock  or  securi- 
ties have  a  market  value.  In  the  absence  of  a  market  value 
the  amount  to  be  set  up  for  purpose  of  depreciation  should 
be  the  fair  cash  value  of  the  property  at  the  time  of  its  acqui- 
sition by  the  corporation.  Similarly,  on  the  formation  of  a 
partnership  the  basis  for  depreciation  is  the  fair  cash  value 
of  the  property  at  the  time  the  partnership  is  entered  into. 
Where  a  bona  fide  gift  is  made  or  property  is  acquired  by 
bequest,  devise  or  descent,  the  value  of  the  property  when 
acquired  by  the  donee  or  beneficiary  is  the  basis  of  deprecia- 
tion to  him. 

In  all  cases  the  investment  in  the  property  should  be 
reduced  by  the  estimated  salvage  or  junk  value  of  the  asset 
at  the  close  of  its  useful  life. 

Measure  of  Annual  Depreciation  Allowance.  The  law  ex- 
pressly specifies  that  the  annual  allowance  for  depreciation 
shall  be  "reasonable."  A  reasonable  allowance  is  usually 
considered  to  be  that  amount  which  is  found  by  dividing  the 


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144      COLUMBIA     INCOME     TAX     LECTURES 

cost  into  as  many  parts  as  the  property  has  years  of  useful 
life  and  deducting  one  part  each  year.  This  requires,  first, 
a  determination  of  the  useful  life  of  the  property.  It  is  con- 
sidered impracticable  by  the  Treasury  to  prescribe  fixed 
definite  rates  of  depreciation  which  should  be  allowable  for 
all  property  of  a  given  class  or  character,  since  many  factors 
may  intervene  to  vary  the  period  of  useful  life.  The  rate  at 
which  property  depreciates  may  depend  upon  its  locality, 
the  purpose  for  which  it  is  used,  and  the  conditions  under 
which  it  is  used  and  the  care  given  to  its  preservation.  The 
same  kind  of  a  building  may  depreciate  more  rapidly  in 
Portland,  Maine,  than  in  Los  Angeles,  California;  and  so  the 
same  rate  need  not  necessarily  be  applied  to  two  buildings 
identical  in  all  respects  except  as  to  location.  Similarly, 
manufacturing  plants  in  the  same  locality,  doing  identically 
the  same  kind  of  business,  may  deteriorate  unequally,  due  in 
large  measure  to  the  management  and  to  the  care  with  which 
repairs  are  made  and  the  property  maintained.  Many  other 
elements  enter  into  the  question,  the  effect  of  which  can  be 
determined  only  by  particular  consideration  and  often  only 
approximately.  The  taxpayer  must,  therefore,  use  his  best 
judgment  and  experience  in  determining  the  rate  at  which 
his  property  depreciates,  and  his  judgment  will  be  subject 
to  the  approval  of  the  Commissioner.  Recognizing  these 
facts,  the  Commissioner  will  not  impute  negligence  or  intent 
to  defraud  in  a  case  where  a  taxpayer  charges  oflf  a  greater 
depreciation  than  deemed  reasonable  by  the  Commissioner, 
unless,  of  course,  the  position  taken  by  the  taxpayer  is  so 
unreasonable  as  to  indicate  either  gross  carelessness  or  bad 
faith. 

The  rate  of  depreciation  may  vary  at  different  times  with 
respect  to  the  same  property.  For  instance,  a  building  put 
to  one  use  may  suffer  comparatively  low  depreciation,  and 
if  put  to  a  different  use  under  which  greater  strain  is  experi- 
enced, the  depreciation  rate  may  justifiably  be  increased. 
Again,  a  machine  under  normal  conditions  may  be  entitled 
to  a  lower  rate  of  depreciation  than  when  operated  overtime 
or  at  an  overload.     It  does  not  follow  necessarily  that  if  a 


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145 


machine,  operating  normally  for  eight  hours  a  day,  is  operated 
for  sixteen  hours  a  day,  it  will  depreciate  twice  as  rapidly  as 
when  operated  under  normal  conditions,  but  undoubtedly 
depreciation  is  accelerated.  No  general  rule  can  be  laid  down 
to  gauge  the  accelerated  depreciation,  and  each  case  must  be 
determined  according  to  its  particular  facts. 

While  the  time  element  is  ordinarily  used  to  ascertain  the 
rate  of  depreciation,  in  some  instances  a  better  measure  may 
be  available.  For  example,  where  it  is  definitely  known  that 
a  particular  machine  is  capable  of  producing  only  a  definite 
number  of  articles  during  its  useful  life,  the  cost  may  be 
divided  by  such  aggregate  number  of  articles,  and  the  depre- 
ciation taken  in  any  one  year  is  then  determined  by  multi- 
plying the  number  of  articles  produced  in  that  year  by  the 
depreciation  rate  so  ascertained.  Thus  the  depreciation  is 
made  to  fluctuate  from  year  to  year  in  proportion  to  the 
activity  of  the  machine. 

Again,  if  a  machine  is  useful  only  in  connection  with  an 
operation,  such  as  drilling  oil  wells  or  perhaps  carrying  on 
lumber  operations  in  remote  districts,  in  which  the  work  to  be 
done  will  terminate  before  the  property  used  in  such  work  is 
actually  worn  out,  depreciation  may  be  claimed  upon  its 
useful  life  in  connection  with  the  particular  operation.  In 
such  cases,  of  course,  the  amount  to  be  wiped  out  by  deprecia- 
tion is  the  cost  less  the  estimated  salvage  value  ot  the  property 
after  the  particular  operation  is  completed. 

It  is  seen,  therefore,  that  the  depreciation  rate  is  not  a  fixed 
conventional  rate,  but  varies  with  the  circumstances  of  each 
particular  case  and  may  vary  from  year  to  year  with  respect  to 
any  particular  property.  By  reason  of  the  difficulty  of 
estimating  accurately  the  rate  of  depreciation  to  be  applied,  it 
may  be  found  that  when  the  property  is  finally  discarded  or 
sold  the  sum  of  the  depreciation  deductions  actually  claimed 
and  the  salvage  value  may  not  be  equal  to  the  original  cost  of 
the  property.  As  a  general  rule,  if  such  sum  is  less  than  the 
cost,  the  difference  may  be  deducted  as  a  loss  in  the  year  in 
which  the  property  is  disposed  of;  if  such  sum  exceeds  the 
cost,  the  excess  must  be  reported  as  income  in  the  year  in 


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146      COLUMBIA     INCOME     TAX     LECTURES 

which  the  property  is  disposed  of.    But  where  the  depreciation 
charged  off  has  been  unreasonably  large— or  unreasonably 
small— so  as  to  indicate  negligence,  carelessness,  or  fraud  on 
the  part  of  the  taxpayer,  the  Commissioner  may  require  the 
depreciation  deductions  for  past  years  to  be  corrected  by 
means  of  amended  returns  in  order  to  arrive  at  true  calculations 
of  net  income  for  each  of  the  several  years.    It  may  be  noted, 
parenthetically,  that  if  our  tax  rates  were  less  subject  to  change 
from  year  to  year,  it  would  be  comparatively  unimportant 
whether  or  not  too  much  or  too  little  depreciation  was  taken  in 
any  particular  year,  since  the  aggregate  amount  would  be 
equalized  over  a  long  period  of  time  without  any  material 
difference  in  the  total  amount  of  tax  paid  by  the  taxpayer. 
However  since  we  have  had  violent  variations  in  tax  rates 
year  after  year  during  the  war  period,  it  has  become  important 
to  determine  accurately  the  precise  amount  of  depreciation 
property  allocated  to  each  year.    For  example,  many  properties 
were  sold  in  1917  and  1918  at  extremely  high  prices;   if  the 
depreciation  claimed  with  respect  to  such  properties  in  prior 
years  had  been  inordinately  small,  the  profit  on  the  sale  of  the 
property  would  be  correspondingly  low,  to  the  detriment  of  the 
revenue;  and  on  the  other  hand,  if  the  depreciation  charged  in 
prior  years  had  been  too  high,  the  profit  on  the  sale  would  have 
been  inordinately  high,  to  the  detriment  of  the  taxpayer  in  a 
year  when  rates  were  excessive.    In  such  extraordinary  cases  a 
readjustment  of  the  depreciation  actually  claimed   might  be 
necessary  or  desirable  equitably  to  determine  the  amount  of 
income  for  tax  purposes  for  each  of  the  years,  in  some  of  which 
the  rates  were  low  and  in  others,  high. 

It  appears  at  times  that  a  mistake  has  been  made  in  the 
estimate  of  the  useful  life  of  a  property,  or  in  its  cost,  in  which 
cases  the  taxpayer  is  privileged  to  readjust  his  depreciation 
allowance  for  the  future  on  the  correct  basis,  subject,  of  course, 
to  the  approval  of  the  Commissioner  of  Internal  Revenue. 

Office  buildings,  steamships,  et  cetera,  are  examples  of 
properties  which  are  of  complex  character  having  many  parts, 
some  long  lived  and  others  short  lived.  In  such  cases  the 
various  elements  of  the  property,  such  as  the  building  itself  or 


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the  hull  of  a  ship,  the  machinery  or  power  plants,  etc.,  may  be 
depreciated  separately  at  varying  rates,  or  a  composite  rate 
for  the  whole  may  be  built  up  by  taking  into  consideration  the 
relative  values  of  each  kind  of  property  in  relation  to  the 
whole  cost.  The  method  of  arriving  at  composite  rates  of 
depreciation  is  admirably  illustrated,  as  applied  to  oil  refineries, 
in  the  so-called  Manual  for  the  Oil  and  Gas  Industry ,  prepared 
by  the  Treasury. 

Some  doubt  still  lingers  about  the  point  of  time  when 
depreciation  commences,  particularly  where  the  erection  of  a 
building  or  plant  requires  much  time.  The  proper  rule,  under 
such  circumstances,  seems  to  be  that  deduction  for  depreciation 
should  commence  in  the  year  when  the  building  or  other 
property  is  put  into  active  use. 

Many  authorities  on  depreciation  advocate  methods  other 
than  the  straight-line  method  of  depreciation  used  by  the 
Treasury,  but  no  other  method  has  received  recognition.  In 
the  straight-line  method  the  rate  is  applied  to  the  prime  cost 
each  year.  There  is,  on  the  other  hand,  much  to  be  said  for 
claiming  depreciation  on  a  diminishing  balance  of  investment, 
for  example,  ten  per  cent,  upon  the  cost  of  the  property  in  the 
first  year;  ten  per  cent,  upon  the  unextinguished  capital,  being 
ninety  per  cent,  of  the  total  cost,  for  the  second  year;  en 
per  cent,  upon  the  unextinguished  balance,  or  eighty  per  cent, 
of  the  cost,  for  the  third  year,  and  so  on.  This  cumulates  a 
depreciation  allowance  in  the  early  years  of  the  life  of  the 
property,  when  its  earning  power  is  likely  to  be  at  its  maximum 
and  the  expenditures  for  repairs  at  the  minimum.  While 
there  is  much  to  be  said  for  this  method  of  measuring  deprecia- 
tion, it  is  not  recognized  for  the  purpose  of  our  Federal  taxes. 

Incidental  Repairs  to  Property  on  Which  Depreciation  Is 
Claimed.  The  useful  life  of  a  property  is  not  the  number  of 
years  it  will  last  without  repair  or  attention.  It  is  presumed 
that  a  certain  amount  of  ordinary  repairs  will  be  made  from 
time  to  time  to  keep  the  property  in  good  condition  and  to 
prevent  deterioration.  The  cost  of  such  repairs  is  a  proper 
annual  expense.  It  may  be  difficult  to  distinguish  between 
incidental  repairs  and  such  repairs  as  in  effect  cause  a  renewal 


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148       COLUMBIA     INCOME     TAX     LECTURES 

or  addition  to  the  property.  There  is  always  an  indistinct 
line  of  demarcation,  but  the  comparative  triviality  or  tem- 
porary character  of  the  repair  is  often  the  best  indication  that 
the  expenditure  is  properly  chargeable  to  expense. 

Closely  related  to  the  subject  of  repairs  is  that  of  renewals. 
It  is  possible  that  worn  out  parts  of  a  machine  or  similar 
equipment  may  be  renewed  one  after  another  until  the  original 
machine  or  equipment  is  swallowed  up  in  renewed  parts.  The 
machine  or  equipment  is  then  in  as  good  oj^erating  condition 
as  it  was  originally,  or  at  least  its  life  has  been  materially 
increased.  In  such  cases  if  the  cost  of  the  renewed  part  is 
customarily  charged  to  operating  expense,  no  deduction  on 
account  of  depreciation  should  be  claimed  as  to  the  machine 
or  equipment;  on  the  other  hand,  if  a  reserve  is  set  up  to 
cover  property  which  may  be  renewed  or  restored  by  parts 
until  the  whole  is  renewed,  the  cost  of  the  renewed  part  should 
be  charged  to  the  depreciation  reserve  fund  and  not  to  expense. 

In  determining  the  rate  of  depreciation,  attention  must 
therefore  be  given  to  the  custom  or  practice  followed  in  making 
repairs  and  replacements. 

Additions  and  Betterments.  Amounts  expended  in  addi- 
tions and  betterments  or  for  fixtures  which  constitute  an 
increase  in  capital  investment  and  add  to  the  value  of  the 
asset  are  not  a  proper  deduction  as  expense,  but  should  be 
added  to  the  capital  investment  to  which  the  depreciation 
rate  is  applied.  A  substantial  addition  or  betterment  may 
require  an  adjustment  of  the  rate  to  the  extent  that  the 
useful  life  of  the  property  is  affected. 

Treatment  of  Excessive  or  Inadequate  Deductions  for  De- 
preciation. It  is  a  well  recognized  fact  that  many  conservative 
business  men  have  followed  the  practice  of  writing  off  heavy 
deductions  for  depreciation.  Others  have  disregarded  depre- 
ciation in  their  annual  balance  sheets.  Consequently  the 
capital  investment  shown  on  the  balance  sheet  does  not 
always  reflect  the  true  cost  less  normal  depreciation.  In 
order  to  arrive  at  the  real  invested  capital  for  purpose  of  the 
excess-profits  tax,  it  is  necessary  to  reconstruct  the  deprecia- 
tion reserve  account  either  by  setting  up  a  proper  reserve 


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149 


where  inadequate  depreciation  had  been  taken  or  to  reduce 
the  reserve  and  thereby  increase  the  surplus  account  where 
excessive  depreciation  had  been  charged  off.  This  is  done  on 
the  theory  that  a  true  surplus  is  affected  by  those  constantly 
occurring  losses  covered  by  depreciation.  A  depreciation 
reserve,  of  course,  is  not  included  as  a  part  of  the  invested 
capital  since  it  is  offset  by  a  corresponding  loss  in  the  value 
of  the  assets  in  respect  to  which  the  reserve  is  set  up. 

Where  depreciation  has  been  claimed  on  the  value  as  of 
February  28,  191 3,  the  depreciation  reserve  may  contain  an 
element  of  appreciation  which  took  place  prior  to  that  date. 
To  illustrate:  Property  which  cost  $1,000  in  1912  and  which 
under  normal  conditions  would  have  depreciated  to  $900  by 
March  i,  1913,  may  in  fact  on  that  date  be  worth  $1,800. 
The  taxpayer  is  therefore  entitled  to  set  up  $1,800  as  his 
capital  invested  in  such  property  and  to  claim  depreciation 
on  that  sum  thereafter.  Of  such  depreciation  allowances, 
one-half,  measuring  the  original  unextinguished  cost  of  the 
property  on  March  i,  1913,  is  disregarded  in  computing  in- 
vested capital,  but  the  remaining  one-half,  representing  the 
appreciation  in  value  prior  to  March  i,  1913,  may  be  added 
to  invested  capital  and  treated  as  earned  surplus.  The  reason 
for  this  is  apparent  on  a  moment's  reflection.  The  increase 
in  value  between  the  date  of  acquisition  and  March  i,  1913, 
is  gain  or  profit  not  subject  to  tax  under  our  income  tax 
laws.  That  gain  or  profit  is  realized  from  year  to  year  through 
the  depreciation  account,  and,  therefore,  while  it  is  not  a 
taxable  profit,  it  is  an  earning  retained  in  the  business  and 
therefore  properly  included  as  an  earned  surplus. 

Bookkeeping  entries  do  not  necessarily  determine  the 
amount  of  taxable  income  or  the  amount  of  assets  of  a  corpora- 
tion, or  the  reduction  in  value  of  property  due  to  exhaustion, 
wear  or  tear,  but  all  of  these  are  matters  of  actual  fact  to  be 
given  consideration,  whether  or  not  evidenced  by  book  entries. 
As  a  condition  to  allowing  the  taxpayer  the  benefit  of  depre- 
ciation deductions,  the  Government  may,  and  does,  however, 
require  proper  records  to  be  kept  in  the  books  of  account  in 
such  manner  that  the  result  will  be  reflected  in  the  taxpayer's 


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150      COLUMBIA     INCOME     TAX     LECTURES 

annual  balance  sheet.  The  depreciation  allowance  should 
be  computed  and  charged  off  with  express  reference  to  specific 
items,  units  or  groups  of  property,  and  the  taxpayer  should 
keep  such  records  as  may  be  readily  verified.  This  does  not 
mean,  necessarily,  that  the  proper  bookkeeping  entries  must 
have  been  made  in  the  year  in  which  depreciation  was  sus- 
tained. The  taxpayer  may  re-open  his  books,  make  proper 
adjustments,  file  an  amended  return  and  show  the  proper 
amount  of  net  income.  If  an  adjustment  is  made  for  past 
years,  proper  adjusting  entries  may  be  made  in  the  year  in 
which  proper  depreciation  allowance  is  finally  determined, 
and  such  entry  will  be  sufficient  to  warrant  the  Commissioner 
in  allowing  the  corresponding  adjustment  in  taxes. 

Depreciation  Reserves.  The  subject  of  depreciation  reserves 
has  been  clarified  by  considerable  discussion  since  the  passage 
of  the  first  income  tax  act  in  1913.  Originally  the  Treasury 
Department  took  the  position  that  such  reserves  must  be 
represented  by  liquid  assets  to  be  held  until  the  replacement 
of  a  particular  property  became  necessary.  The  present  rule, 
however,  is  that  the  amounts  allowed  for  depreciation  may 
be  invested  in  any  property  at  the  pleasure  of  the  taxpayer. 
It  may  not,  however,  be  distributed  to  the  stockholders  until 
all  of  the  earnings  of  the  corporation  accrued  after  March  i, 
1 913,  have  first  been  distributed.  A  distribution  from  a 
reserve  for  depreciation  will  be  considered  as  a  partial  dis- 
tribution of  the  capital  of  a  corporation  and  will  constitute 
taxable  income  to  a  stockholder  to  the  extent  that  the  aggre- 
gate of  amounts  so  received  exceed  the  cost  (or  fair  market 
value  as  of  March  i,  1913)  of  his  shares  of  stock.  If  a  corpora- 
tion has  computed  its  net  income  for  a  taxable  period  without 
having  made  an  allowance  for  depreciation  and  then  distri- 
buted the  entire  net  income  to  its  stockholders,  so  that  the 
books  show  no  surplus  or  undivided  profits,  it  may  reopen 
its  books  for  the  purpose  of  exercising  the  privilege  of  deduct- 
ing the  allowance  for  depreciation.  The  corporation  is  then 
in  a  position  of  having  paid  out  a  part  of  its  dividends  from 
the  depreciation  reserve  so  constructed,  or  from  capital,  to 
the  extent  that  the  amount  of  dividends  exceeds  the  true 


LOSSES 


151 


net  income;  that  is,  the  net  income  after  making  the  proper 
charges  for  depreciation.  The  stockholders  must  then  amend 
their  returns  to  show  the  amount  of  dividends  actually  paid 
from  earnings  and  the  amount  paid  from  depreciation  reserve 
or  capital ;  and  they  will  then  be  taxed  accordingly.  Naturally 
the  invested  capital  of  the  corporation  for  excess-profits  tax 
purposes  will  be  deemed  to  have  been  reduced  to  the  extent 
of  the  partial  liquidation. 

Obsolescence 

Depreciation  is  the  loss  due  to  exhaustion,  wear  and  tear. 
Obsolescence  is  the  loss  due  to  the  necessity  of  discarding 
property  because  it  has  become  inadequate  or  incapable  of 
being  used  in  competition  with  more  modern  and  effective 
things,  or  because  the  market  for  the  article  it  produces  will 
disappear  before  the  producing  property  is  exhausted.  Both 
tangible  and  intangible  property  may  be  subject  to  obsoles- 
cence, but  no  deduction  for  tax  purposes  was  specifically 
recognized  by  statute  until  the  passage  of  the  191 8  law,  which 
allows,  in  addition  to  a  deduction  for  exhaustion,  wear  and 
tear  of  property,  "a  reasonable  allowance  for  obsolescence." 
A  thing  may  become  obsolescent  from  either  one  or  two 
causes: 

(a)   The  discovery  or  invention  of  some  better  thing  to  take 
its  place,  which  is  called  obsolescence  by  supercession, 
or 
(6)  The  disappearance  of  the  market  for  the  thing  produced 

by,  or  sold  under,  the  obsolescing  property. 
Illustrations  of  the  first  kind  of  obsolescence  are  common  in 
every-day  life.  The  horse  car  gave  place  to  the  cable  car,  the 
cable  car  was  in  turn  displaced  by  the  trolley  car.  In  railroads 
the  wooden  car  was  displaced  by  the  steel  car.  In  all  of  these 
cases  the  cars  may  have  had  the  possibility  of  long  life,  but 
the  appearance  of  a  better  thing  necessitated  their  displace- 
ment. 

Before  the  enactment  of  the  191 8  law,  the  loss  arising  from 
this  obsolescence  could  not  be  considered  by  the  taxpayer  until 


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152       COLUMBIA     INCOME     TAX     LECTURES 


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the  obsolesced  property  was  actually  sold  or  otherwise  dis- 
posed of.  Under  the  191 8  law,  it  may  be  taken  into  consider- 
ation  as  soon  as  the  new  invention  points  to  the  certain  replace- 
ment of  the  old.  For  example,  if  a  new  type  of  telephone 
should  be  invented  so  infinitely  superior  to  the  one  now  in  use 
that  it  would  be  demanded  by  all  telephone  users,  the  present 
equipment  of  the  telephone  companies  would  become  valueless 
as  soon  as  the  new  equipment  could  be  made  and  installed. 
A  deduction  for  obsolescence  could  be  based  upon  an  estimate 
of  the  time  it  would  take  to  replace  the  old  device  by  the  new. 
In  the  case  of  buildings,  it  may  be  found  that  a  steady  change 
in  the  character  of  a  neighborhood,  or  the  construction  of  new 
and  superior  buildings,  may  in  the  course  of  a  definite  period 
of  time  render  a  particular  building  unfit  for  its  present  use. 
A  building  used  for  manufacturing  may  become  useful  only 
as  a  warehouse.  If  this  can  be  definitely  shown  to  the  satisfac- 
tion of  the  Commissioner,  an  allowance  for  obsolescence 
would  be  permissible,  in  addition  to  an  allowance  for  depre- 
ciation. The  useful  life  of  a  building  may  not  be  diminished, 
but  the  character  of  its  use  may  be  changed  and  thereby  a 
substantial  part  of  its  value  may  be  lost. 

It  has  been  argued  that  experience  shows  in  certain  lines  of 
trade  a  replacement  of  machinery  every  ten  years,  let  us  say, 
but  mere  past  experience  will  not  of  itself  authorize  a  deduc- 
tion for  obsolescence.  The  new  thing  which  will  inevitably 
supersede  the  present  thing  must  have  appeared  before  the 
period  of  obsolescence  is  measurable.  It  was  ably  argued 
with  respect  to  freight  steamers  on  inland  waters  that  expe- 
rience had  shown  that  new  types  of  vessels  were  consistently 
replacing  the  old,  but  the  Government  nevertheless  held  that 
until  a  new  type  of  steamer  appears  it  will  be  assumed  that 
the  latest  type  in  existence  is  the  ultimate  type. 

Obsolescence  due  to  the  loss  of  a  market  is  very  clearly 
illustrated  in  the  case  of  brewers  and  distillers  whose  market 
was  destroyed  by  the  passage  of  the  prohibition  law.  This 
theory  of  obsolescence  has  been  applied  not  only  to  the  physi- 
cal property  of  distilleries  and  breweries,  but  to  vineyards  and 
other  industries  which  depended  upon  the  market  for  spirits, 


LOSSES 


153 


wines  and  beers.  It  was  also  applied  to  such  intangible  prop- 
erty as  goodwill  on  the  ground  that  the  goodwill  would  disap- 
pear with  the  market  at  a  point  of  time  definitely  known  as 
early  as  January,  19 18,  when  the  first  indication  appeared 
that  the  prohibition  amendment  would  be  ratified  by  the 
requisite  number  of  states.  From  that  time  on,  the  value  of 
the  goodwill  would  obsolesce  until  its  final  disappearance 
when  the  taxpayer  ceased  business,  and,  in  any  event,  not 
later  than  January  16,  1920,  when  prohibition  would  become 

effective. 

To  sustain  a  claim  for  deduction  for  obsolescence  of  good- 
will, it  must  be  shown  that  the  goodwill  will  be  of  no  value  at 
the  close  of  an  approximately  definite  period,  and  that  the 
taxpayer  will  be  forced  to  discontinue  the  business  and  be 
unable  to  continue  in  any  similar  business.  Indications  that 
the  value  of  goodwill  is  lessening  from  time  to  time  are  not 
sufficient  to  warrant  a  claim  for  obsolescence. 

An  allowance  for  obsolescence  of  goodwill  will  be  made 
only  in  connection  with  such  goodwill  as  is  assignable,  as 
distinguished  from  goodwill  attaching  to  individuals  owning 
or  conducting  a  business,  or  to  the  premises  at  which  it  is  or 
was  conducted;  and  no  allowance  for  obsolescence  will  be 
granted  in  any  case  where,  in  connection  with  the  operation  of 
the  business,  the  goodwill  will  be  valuable  in  another  business 
after  the  termination  of  the  business  in  which  the  taxpayer  is 
engaged. 

The  principles  of  obsolescence  are  as  yet  dim  and  obscure, 
but  the  tendency  of  the  Treasury  is  to  allow  the  benefit  freely 
to  taxpayers  where  the  fact  of  obsolescence  can  be  definitely 
shown  and  the  point  of  time  of  complete  disappearance  of 
value  can  be  definitely  ascertained.  Only  property  used  in 
the  taxpayer's  trade  or  business  is  subject  to  this  allowance 
and  in  general  the  rules  applicable  to  depreciation  extend  by 
analogy  to  obsolescence. 

Amortization  of  War  Facilities 

Definition  and  History  of  Statutory  Provision.  The  term 
amortization  as  here  used  means  provision  for  meeting  a  loss 


154      COLUMBIA     INCOME     TAX     LECTURES 

of  value  of  property  and  facilities  acquired  expressly  for  war- 
time activity  resulting  from  the  sudden  cessation  of  that 
activity. 

The  191 6  law  made  no  provision,  either  in  the  original 
act  or  as  amended  by  the  Act  of  October  3,  191 7,  for  the 
amortization  of  plants  or  equipment  acquired  for  or  used  in  the 
production  of  articles  necessary  to  carry  on  the  war.  The 
first  provision  for  amortization  appears  in  the  Revenue  Act 
of  1918:* 

In  the  case  of  buildings,  machinery,  equipment,  or  other  facilities, 
constructed,  erected,  installed,  or  acquired,  on  or  after  April  6,  191 7,  for 
the  production  of  articles  contributing  to  the  prosecution  of  the  present 
war,  and  in  the  case  of  vessels  constructed  or  acquired  on  or  after  such 
date  for  the  transportation  of  articles  or  men  contributing  to  the 
prosecution  of  the  present  war,  there  shall  be  allowed  a  reasonable 
deduction  for  the  amortization  of  such  part  of  the  cost  of  such  facilities 
or  vessels  as  has  been  borne  by  the  taxpayer,  but  not  again  including 
any  amount  otherwise  allowed  under  this  title  or  previous  acts  of 
Congress  as  a  deduction  in  computing  net  income. 

This  provision  lacks  definiteness  as  to  the  amount  of  the 
capital  which  may  be  amortized,  except  that  it  states  the 
deduction  shall  be  reasonable.  Some  light  is  shed  on  the 
intention  of  Congress  by  the  statement  made  by  Senator 
Simmons  on  the  floor  of  the  Senate,  during  the  discussion  of 
the  bill.    In  answer  to  a  question,  he  said: 

I  can  answer  the  Senator  generally  by  saying  that  if  by  reason  of  the 
investment  of  his  profits  in  an  extension  of  his  yards  he  has  constructed 
a  plant  which  was  necessary  in  time  of  war  to  meet  the  demands  which 
were  made  upon  him  at  that  time  for  production,  but  which  after  the 
termination  of  the  war  has  depreciated  in  value  because  not  needed ;  in 
that  case,  under  the  amortization  provision  he  will  be  allowed  to 
amortize  to  the  full  extent  of  the  depreciation  in  value.  Of  course,  if 
there  is  salvage  he  would  be  allowed  to  amortize  only  down  to  the 
salvage  value.* 

A  consideration  of  the  provision  in  the  light  of  the  circum- 
stances at  the  time  it  was  adopted  leads  to  the  following 
conclusions : 

After  our  entry  into  the  war  an  abnormal  activity  took 
place.     Men  actuated  by  patriotic  motives  and  disregarding 

*  Provision  for  amortization  appeared,  however,  in  the  earlier  Munitions  Tax  Act. 
» Congressional  Record,  February  17,  1919,  p.  3774. 


LOSSES 


155 


sound  business  judgment  entered  upon  extended  enlargement 
of  plants,  or  the  creation  of  new  plants,  in  order  to  supply  the 
needs  of  the  country.    Production  was  encouraged  everywhere. 
It  was  evident  that  demand  for  the  articles  produced  would 
cease  or  materially  diminish  when  the  war  ended.    Costs  were 
abnormally  high  and  their  ordinary  effect  on  business  was 
ignored.     Speed  was  the  essence,  and  adding  to  the  high 
costs  due  to  inflation  were  the  bonuses  for  prompt  delivery, 
extra  overtime  pay  and  extra  charges  for  rapid  transporta- 
tion.    A  further  deterrent  to  expansion  was  the  abnormally 
high   war-profits  tax.     Under  ordinary   conditions   the  cost 
of  plant  and  equipment  would  be  charged  off  over  the  useful 
life  of  the  property.     But  such  conduct  would  have  been 
ruinous  in  the  case  of  those  who  put  up  plants  for  the  specific 
purpose  of  assisting  in  the  carrying  on  of  the  war.     It  was 
necessary,  therefore,  to  allow  the  extraordinary  cost  of  special 
plants  and  facilities  to  be  charged  against  the  income  pro- 
duced by  the  extraordinary  effort  which  necessitated  their 
construction  before  assessing  an  abnormally  high  war  tax. 

Examining  the  statute  with  this  in  mind,  it  is  noted  that  the 
act  does  not  apply  to  any  property  constructed  or  acquired 
before  our  entry  into  the  war  or  after  the  armistice  was  signed, 
which,  of  course,  marked  the  end  of  the  extraordinary  demand 
for  means  of  production. 

The  kind  of  property  which  may  be  amortized  is  stated  in 
the  statute.  It  includes  buildings,  machinery,  equipment,  or 
other  facilities,  for  the  production  of  articles  contributing  to 
the  prosecution  of  the  war,  and  vessels  for  the  transportation 
of  articles  or  men  contributing  to  the  prosecution  of  the  war. 
The  first  test,  therefore,  is  the  production  of  the  plant.  The 
statute  does  not  state  that  the  articles  should  be  manufactured 
for  this  Government,  or  that  the  taxpayer  should  have  oper- 
ated under  a  Government  contract.  Consequently,  others 
may  also  claim  the  benefit  of  the  provision  if  it  can  be  shown 
the  property  was  used  to  produce  articles  contributing  to  the 
prosecution  of  the  war.  Practically  every  essential — ^and  some 
non-essentials — contributed  to  that  purpose,  and  seemingly 
the  word  "article"  and  the  word  "contributing"  should  be 


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156      COLUMBIA     INCOME     TAX     LECTURES 

broadly  construed  to  take  in  every  activity  where  the  taxpayer 
can  show  his  production  to  have  directly  or  indirectly  aided  in 
the  success  of  the  Allied  cause.  The  statute  does  not  indicate 
that  the  articles  should  be  used  in  the  battle  area.  Many 
things  used  here  contributed  to  the  prosecution  of  the  war. 
In  fact,  it  is  difficult  to  exclude  any  but  the  most  unessential 
articles  from  the  broad  phrase  used  in  the  statute. 

It  also  seems  clear  that  the  intent  of  the  statute  is  that  the 
allowance  for  amortization  shall  generally  be  applied  to  the 
income  of  the  year  19 18,  regardless  of  when  it  is  finally  deter- 
mined. In  some  cases,  where  the  war  activity  ran  over  into 
1919  or  the  income  from  that  activity  was  received  in  1919, 
the  allowance  should  be  apportioned  between  the  two  years. 

The  measure  of  the  amount  of  the  amortization  allowance  is 
more  difficult  to  state.  Clearly  it  is  not  intended  to  be  the 
entire  cost  in  every  case,  for  that  would  leave  the  taxpayer  too 
well  off  as  a  result  of  his  war  activity.  Senator  Simmons  said 
it  was  the  cost  less  salvage  value.  The  statute  provides  for  a 
period  of  three  years  in  which  finally  to  determine  the  amount 
of  the  allowance. 

It  seems,  therefore,  that  if  the  taxpayer  sells  the  property  at 
any  time  within  that  period,  he  may  deduct  the  loss  from  his 
income  for  191 8.  In  calculating  the  loss,  certain  unusual  facts 
may  perhaps  have  to  be  considered,  as  for  instance  the  loss  of 
interest  on  the  investment  up  to  the  time  he  found  a  buyer, 
the  extent  to  which  he  may  have  made  the  property  more 
valuable  after  the  war,  by  reconstruction  or  otherwise,  in  order 
to  obtain  a  buyer,  and  many  other  facts.  What  should  be 
allowed  is  limited  only  by  the  phrase  "reasonable  deduction," 
and  within  that  limit  the  Commissioner's  judgment  and 
discretion  would  govern. 

If  that  is  the  procedure  in  the  case  of  the  taxpayer  who  has 
sold  his  property,  what  should  be  done  in  the  case  of  one  who 
could  not  sell  or  who  elected  to  use  the  property  to  its  full 
capacity  or  part  capacity  in  post-war  activities? 

Inability  to  sell  might  be  caused  by  inability  to  find  a  pur- 
chaser. In  such  case,  if  the  property  is  discarded  and  not  used 
in  post-war  activity,  all  the  investment,  less  junk  value,  would 


LOSSES 


157 


be  deductible.  If  the  property  is  not  saleable,  by  reason  of 
being  a  part  of  the  taxpayer's  old  plant,  which  cannot  con- 
veniently be  used  by  another,  and  the  taxpayer  has  no  use  for 
it  by  the  end  of  the  three-year  period,  it  would  seem  that  all  ex- 
cept the  salvage  value  would  be  deductible.  If  he  finds  use  for 
it  within  the  three-year  period,  the  value  to  him  would  perhaps 
be  deductible  from  the  cost  and  the  remainder  amortized. 

Cases  will  no  doubt  arise  where  taxpayers  find  the  property 
of  use  to  them  in  its  full  capacity  within  the  three-year  period. 
In  such  cases  a  reasonable  allowance  would  probably  be  the  dif- 
ference between  the  actual  cost  and  a  fair  replacement  value 
under  stable  post-war  conditions  so  far  as  such  conditions  are 
indicated  within  or  foreseen  at  the  close  of  the  three-year 

period. 

Tentative  claims  for  amortization  are  contemplated  by  the 
law  and  were  made  by  many  taxpayers  in  their  returns  for  the 
year  19 18.  The  Commissioner  made  many  rulings  to  control 
these  tentative  deductions,  some  of  which  were  protested  by 
taxpayers  generally  and  modified.  The  purpose  of  the  Com- 
missioner was,  of  course,  to  prevent  exorbitant  claims  from 
being  filed,  and  it  became  a  matter  of  much  importance  to  the 
taxpayer  to  justify  his  claim  by  the  best  evidence  obtainable. 

No  general  rule  could  be  made  or  method  prescribed  to  indi- 
cate the  amount  which  might  be  claimed  tentatively.  In  any 
claim  made  before  the  close  of  the  three-year  period,  a  part  of 
the  claim  must  necessarily  deal  with  the  amortization  then 
determined  by  sales  or  other  definite  measure,  and  the  other 
part  with  an  amount  estimated  as  likely  to  occur  before  normal 
post-war  conditions  are  reached.  The  British  rule,  in  this 
respect,  has  been  to  assume,  tentatively,  that  post-war  values 
will  be  approximately  pre-war  values  and  to  make  adjust- 
ments with  the  taxpayer  on  that  basis,  subject  to  revision  and 
increase  of  the  tax  if  that  assumption  proves  to  be  incorrect. 

Losses  Due  to  Casualties  and  Theft 
While  our  income  tax  statutes  have  limited  deduction  for 
losses  arising  from  transactions  in  property  to  the  taxpayer's 
trade  or  business,  or,  under  the  later  laws,  to  transactions 


H 


«  ', 


158      COLUMBIA     INCOME     TAX     LECTURES 

entered  into  for  profit,  and  limited  deductions  for  depreciation 
and  obsolescence  to  property  employed  in  the  business,  losses 
arising  from  fire,  storm,  shipwreck  or  other  casualty,  or  from 
theft,  are  deductible  whether  or  not  the  property  was  used  in 
the  business  of  the  taxpayer.  This  appears  to  be  a  departure 
from  the  general  theory  of  taxable  income.  The  result  is  that 
if  a  taxpayer's  residence  is  sold  at  a  loss  the  loss  cannot  be  de- 
ducted, but  if  his  residence  is  destroyed  by  fire  his  loss  may  be 
deducted.  This  exception  to  the  general  rule  is  apparently 
intended  to  lessen  the  rigor  of  the  tax  in  the  case  of  individuals 
who  have  had  the  misfortune  to  lose  capital  through  causes  be- 
yond their  control.  It  should  be  noted  that  the  loss  must  be 
one  due  to  an  act  beyond  the  control  of  the  taxpayer. 

A  loss  due  to  voluntary  destruction  of  the  property  is  not 
deductible  under  this  head.  For  example,  land  may  be 
purchased  on  which  good  and  substantial  buildings  exist  at  the 
time  of  the  purchase.  Naturally  the  price  paid  for  the  prop- 
erty includes  the  value  of  such  buildings.  The  purchaser, 
however,  intends  to  construct  a  different  kind  of  building  on 
the  property  and  his  first  step  is  to  demolish  and  remove  the 
old  buildings.  The  loss  resulting  from  such  demolition  and 
removal  is  not  deductible  from  his  income  tax,  but  the  entire 
cost  of  the  property,  including  the  cost  of  removal  of  the  old 
buildings,  is  held  to  be  his  capital  investment.  If,  how- 
ever, old  buildings  are  demolished  or  old  machinery  is  scrapped 
in  the  course  of  a  going  business,  the  deduction  of  the  net 
amount  of  the  loss  to  the  taxpayer  may  be  made  in  the  year 
in  which  the  property  is  discarded.  The  rules  applying  in 
such  case  are  stated  in  the  discussion  on  depreciation. 

The  deduction  of  losses  arising  from  fire,  storm,  ship- 
wreck, or  other  casualty  or  theft,  is  usually,  though  not 
necessarily,  limited  to  physical  property, — in  the  case  of 
non-resident  aliens  only  with  respect  to  property  located  in  the 
United  States,  and  in  the  case  of  foreign  corporations  only 
if  and  to  the  extent  the  property  is  connected  with  income 
arising  from  a  source  within  the  United  States.  In  the  case 
of  a  citizen  or  resident,  or  a  domestic  corporation,  the  loss 
may  be  deducted  regardless  of  where  the  property  is  situated. 


LOSSES 


159 


The  year  in  which  the  loss  may  be  deducted  is  still  a  matter 
of  uncertainty  under  the  statute.  In  the  earlier  laws  it  was 
provided  that  a  deduction  could  be  had  only  for  losses  actually 
sustained  during  the  year.  Under  the  present  statute  the 
word  "actually"  is  omitted,  and  in  many  instances  it  becomes 
important  to  determine  whether  the  loss  is  sustained  in  the 
year  in  which  the  casualty  or  theft  may  actually  have  hap- 
pened, or  in  the  year  in  which  it  is  discovered  by  the  taxpayer, 
or  in  the  year  the  precise  amount  of  the  loss  is  finally  ascer- 
tained. In  a  recent  case,  apparently  never  reported,  it  was 
held,  under  the  Corporation  Act  of  1909,  where  an  embezzle- 
ment was  discovered  several  years  after  it  took  place,  the  time 
of  the  discovery  of  the  loss  bore  no  relation  to  the  date  of  the 
loss.  The  loss  was  sustained  when  the  theft  occurred,  and  the 
taxpayer  was  not  entitled  to  any  deduction  in  the  year  in 
which  it  was  discovered.  The  rule  in  the  Treasury  seems  to 
be  that  the  taxpayer  shall  reopen  his  return  for  the  year  in 
which  the  loss  actually  took  place  and  amend  his  statement 
of  net  income  accordingly.  The  development  of  the  law 
on  this  point,  however,  has  not  proceeded  so  far  that  definite 
rules  can  be  laid  down  applicable  to  all  cases. 

The  net  amount  which  may  be  deducted  as  a  loss  by  a  tax- 
payer is  the  value  of  the  property  on  February  28,  1913,  or  its 
cost  if  acquired  after  that  date  less  proper  depreciation  to  the 
date  of  sale,  and  less  also  any  amount  received  as  compensation 
by  way  of  insurance,  and  any  salvage  value  which  the  property 
may  have.  If  after  this  computation  has  been  made  it  appears 
that  in  a  subsequent  year  the  taxpayer  receives  further  com- 
pensation for  the  loss  by  way  of  insurance  or  otherwise,  such 
compensation  is  not  income  in  the  year  in  which  it  is  received, 
but  should  be  applied  to  a  reduction  of  the  loss  in  the  year  in 
which  the  loss  was  sustained.  This  may  not,  however,  be  a 
definite  rule  in  all  cases,  and  perhaps  may  be  cited  only 
as  an  indication  of  the  lines  of  development  of  this  point 
of  the  law. 


• 


INVENTORIES 


l6l 


INVENTORIES 

BY 

Arthur  A.  BALLANtiNE 

Until  recently  inventories  were  not  the  subject  of  much 
theoretical  discussion.  They  were  handled  by  practical  men 
in  a  practical  way.  Where  not  unduly  influenced  by  stock 
market  considerations,  business  men  took  them  and  valued 
them  conservatively,  so  as  not  to  over-state  their  profits  or 
worth.  The  imposition  since  191 7  of  extraordinarily  heavy 
taxes  on  income  has  led  taxing  officials  to  lay  down  rules  for 
taking  inventories  designed  to  result  in  full  disclosure  of  in- 
come, and  the  desire  to  get  the  benefit  of  using  as  invested 
capital  the  full  allowable  earned  surplus  has  prompted  busi- 
ness men  themselves  to  revise  understatements  of  inventories 
for  previous  years,  made  on  the  basis  of  their  original  conserva- 
tive practices.  The  great  slump  in  commodity  values,  now  con- 
tinuing, shows,  however,  how  income,  computed  and  taxed  on  a 
maximum  basis,  may  prove  to  have  been  illusory.  It  is  a 
fitting  time  to  sum  up  the  rulings  which  have  been  made  about 
the  use  of  inventories  and  to  consider  how  those  rulings  should 
be  modified  to  promote  fairness  in  the  levying  of  tax  burdens 
and  stability  in  business  practices. 

Function  of  Inventories:  Its  Recognition 

IN  THE  Tax  Law 

As  income  from  a  business  consists  broadly  of  the  excess  of 
assets  at  the  end  of  the  year  over  assets  at  the  beginning  of  the 
year,  it  cannot  be  computed  without  bringing  into  account  the 
goods  on  hand  at  the  beginning  and  at  the  end  of  the  year. 
The  first  provision  as  to  inventories  appearing  in  the  law,  how- 
ever, is  Section  203  of  the  1918  law,  reading  as  follows: 

That  whenever  in  the  opinion  of  the  Commissioner  the  use  of 
inventories  is  necessary  in  order  clearly  to  determine  the  income  of  any 


taxpayer,  inventories  shall  be  taken  by  such  taxpayer  upon  such  basis 
as  the  Commissioner,  with  the  approval  of  the  Secretary,  may  prescribe 
as  conforming  as  nearly  as  may  be  to  the  best  accounting  practice  in 
the  trade  or  business  and  as  most  clearly  reflecting  the  income. 

In  the  earliest  act  passed  by  authority  of  the  Sixteenth 
Amendment  (Act  of  October  3, 1913)  and  also  under  the  second 
act  (Act  of  September  8,  1916)  net  income  was  treated  as  con- 
sisting essentially  of  the  excess  of  cash  receipts  over  expendi- 
tures and  no  mention  was  made  of  inventories.  The  first  pro- 
vision of  the  law  contemplating  any  other  basis  of  income 
determination  was  that  of  Section  13  (d)  of  the  Act  of  Septem- 
ber 8,  1916,  which  recognized  that  corporations  might  render 
their  returns  upon  the  basis  of  accounts  kept  upon  a  basis 
"other  than  that  of  actual  receipts  and  disbursements,"  pro- 
vided that  in  the  opinion  of  the  Commissioner,  such  other  basis 
clearly  reflected  its  income. 

From  the  outset,  however,  it  was  recognized  under  the 
regulations  that  at  least  in  the  case  of  certain  corporations, 
inventories  were  necessary.  (In  principle,  there  is,  of  course, 
no  basis  for  distinguishing  between  the  accounting  of  a  cor- 
poration engaged  in  business  and  that  of  an  individual  or 
partnership  engaged  in  business.)  Accordingly  Regulations 
33,  issued  January  5,  1914,  provided  for  the  use  of  inventories 
"by  certain  classes  of  corporations,"  although  it  did  not  specify 
the  basis  for  pricing  such  inventories.^  Under  Regulations  33 
(Revised),  issued  in  January,  1918,  after  the  vital  changes 
effected  by  the  Act  of  October  3,  1917,  the  treatment  of  inven- 
tories remained  crude,  no  provisions  being  made  as  to  most 
points  of  importance.'  So  far  as  forms  were  concerned,  it  was 
not  until  the  appearance  of  Form  1031,  issued  in  October, 
1 91 6,  for  the  return  of  income  by  corporations,  that  any 
instructions  as  to  the  pricing  basis  were  given.  The  basis  set 
forth  in  small  type  on  the  back  of  that  form  was  cost.'    It  was 

» Art.  161. 

•Par.  353.  354.  396.  481. 

» "All  manufacturing,  mercantile  or  other  corporations  which  determine  their  annual 
gain  or  loM  by  inventory  are  required  to  state  the  same  in  the  form  indicated  below.  If 
the  annual  income  or  loss  is  determined  otherwise  the  methods  employed  must  be  stated 
in  the  space  provided  therefor.  In  case  the  annual  gain  or  loss  is  determined  by  inventory, 
merchandise  must  be  inventoried  at  the  cost  price,  as  any  loss  in  saleable  value  wiU  ulti- 
mately be  reflected  in  the  sales  during  the  year  when  the  goods  are  disposed  of.* 


i 

1 1 
.  ( 


' 


) 
I 


l62       COLUMBIA     INCOME     TAX     LECTURES 

with  the  promulgation  on  December  19,  191 7,  of  Treasury 
Decision  2609,  authorizing  inventories  to  be  taken  at  "cost  or 
market  whichever  is  lower",  that  the  subject  first  began  to 
assume  under  the  regulations  the  importance  which  it  deserves. 
There  is  now  in  the  Bureau  a  special  and  active  section  on 
inventories,  and  it  is  recognized  by  the  Treasury  that  there  is 
hardly  any  subject  of  greater  practical  importance,  and 
probably  none  as  to  which  so  much  divergence  has  existed  in 
actual  practice. 

Schedule  A  and  Schedule  A-2:  Schedule  A  of  Form  1 120  (the 
corporation  income  and  excess  profits  return),  on  which  the 
entire  income  computation  is  briefly  set  forth,  calls,  in  line  2, 
for  a  deduction  from  the  amount  of  gross  sales  of  the  cost  oj 
goods  sold  brought  forward  from  Schedule  A-2.  It  is  on 
Schedule  A-2,  which  has  to  be  separately  made  out,  that  the 
use  is  actually  made  of  the  inventory  figures.  The  taxpayer 
is  there  required  to  put  down  the  inventory  at  the  beginning 
of  the  period;  to  add  to  it  purchases  during  the  period,  labor 
and  wages  ordinarily  charged  to  manufacturing  cost  and 
other  expenses  ordinarily  charged  to  such  cost,  and  from  the 
total  so  arrived  at  to  deduct  the  inventories  at  the  close  of  the 
period.  The  result  so  arrived  at  is  to  be  taken  as  the  cost  of 
goods  sold.  It  results  accordingly  that  the  larger  the  amount 
of  the  inventory,  the  smaller  is  the  cost  of  the  goods  sold,  and 
the  larger  the  income. 

It  is  not  required,  under  the  regulations  or  instructions 
given  on  the  form,  that  the  schedule  be  made  up  according  to 
the  exact  method  primarily  indicated,  but  no  method  of 
getting  at  "cost  of  goods  sold"  which  does  not  take  inventories 
into  account  would  be  approved.  The  inventory  used  at  the 
beginning  of  the  year  must  be  the  same  as  the  closing  inventory 
for  the  previous  year. 

The  use  of  inventories  as  required  by  Schedule  A-2  priced  on 
a  basis  which,  in  the  case  of  goods  manufactured  by  the  tax- 
payer, is  to  include  a  proper  allotment  of  overhead  costs  and 
perhaps  also  repairs  and  other  items  which  are  separately 
deducted  on  Schedule  A  in  computing  net  income,  has  the 
effect  of  restoring  in  part  deductions  made  under  Schedule  A. 


INVENTORIES 


163 


The  restoration  of  expense  so  made  may  be  very  important, 
as  in  the  case  of  unit  depletion  deductions  in  the  case  of  mines. 
This  restoration  of  expressly  authorized  deductions  might 
seem  not  to  be  required  by  law,  but  under  the  present  law 
income  determination  is  not  so  much  a  matter  of  literal  appli- 
cation of  specific  provisions  as  a  matter  of  proper  accounting. 
Under  the  general  method  of  accrual  accounting  usually 
applied  to  industries  of  any  size,  such  a  restoration  of  expense 
through  inventory  is  proper  and  necessary.  Its  effect  is 
simply  to  make  a  particular  item  of  expense  follow  the  goods 
to  which  it  applies,  and  be  taken  as  a  deduction  only  when 
such  goods  are  sold. 

Who  Are  To  Use  Inventories 

Taxpayers  Engaged  in  a  Trade  or  Business:  Inventories  are 
prescribed  in  the  case  of  those  trades  or  businesses  "in  which 
the  production,  purchase  or  sale  of  merchandise  is  an  income 
producing  factor."*  The  merchandise  must  be  such  as  to  be 
capable  of  being  inventoried ;  the  use  of  inventories  for  "those 
engaged  in  the  culture  of  oysters"  is  thus  excluded.^  In  the 
case  of  farmers,  the  use  of  inventories  is,  however,  still  op- 
tional.* In  all  other  cases  in  which  inventories  may  be  used, 
their  use  is  apparently  non-compulsory. 

Dealers  in  Securities.  Where,  at  an  established  place  of 
business,  securities  are  handled  as  merchandise  that  is,  for 
purchase  from  and  sale  to  customers  with  a  view  to  the  profit 
so  derived,  the  use  of  inventories  of  the  securities  is  permitted, 
provided  the  dealer  "in  his  books  of  account  regularly  inven- 
tories unsold  securities  on  hand,  either  (a)  at  cost,  or  (b)  at 
cost  or  market  value,  whichever  is  lower"  and  consistently 
adheres  to  the  method  indicated.  If  securities  are  handled  as 
merchandise  in  a  branch  of  the  business  only,  it  is  only  the 
securities  handled  in  that  branch  which  may  be  inventoried.* 

*Art.  is8i;  A.  R.  R.  217.  32-20-11  IS-  Where  not  otherwise  specified  references  to 
articles  are  to  those  included  in  Regulations  45. 

*  Bulletin.  35-20-1168. 

•  Art.  38. 

'  Art.  1585. 


3? 


l64      COLUMBIA     INCOME     TAX     LECTURES 


INVENTORIES 


165 


1 

■1 

^HH" 

1 

Investors  Not  to  Use  Inventories.  It  has  been  urged  that  the 
use  of  the  inventory  method  should  be  permitted  to  any  indi- 
vidual investor  and  should  not  be  restricted  to  dealers,  but  the 
Treasury  has  hitherto  refused  to  permit  this,  even  in  the  case 
of  extensive  investors.  Section  203  contemplates  primarily 
the  use  of  inventories  "in  trade  or  business,"  but  it  would  seem 
that  under  the  general  power  to  approve  methods  of  account- 
ing which  clearly  reflects  actual  income  the  Commissioner 
might  permit  the  use  of  inventories  to  individual  investors  if  he 
should  deem  this  advisable.  The  serious  difficulty  in  deter- 
mining and  checking  up  market  prices  of  securities  not  dealt  in 
upon  any  exchange  might  be  met  by  refusing  to  permit  any 
market  price  to  be  used  unless  that  price  could  be  very  clearly 
established.  Unless  permission  was  given  to  inventory  securi- 
ties at  market  when  above  cost,  as  well  as  when  below,  the 
extension  of  the  use  of  the  inventory  method  to  private  inves- 
tors would  not  operate  to  relieve  from  the  hardship  of  being 
obliged  to  take  all  the  gain  on  securities  as  a  profit  in  the  year 
when  realized  by  sale,  but  it  would  make  it  possible  to  take  as 
a  deduction  a  shrinkage  in  the  value  of  unsold  securities.  It 
would  operate  to  prevent  the  applying  against  income  of  a 
single  year  through  the  whole  of  a  shrinkage  in  the  value  of 
securities  occurring  through  several  years. 

When  Inventories  Must  Be  Taken 

The  law  prescribes  as  a  fundamental  requirement  that  in- 
come is  to  be  computed  "upon  the  basis  of  the  taxpayer's 
annual  accounting  period."  ^  Accordingly,  there  is  required  an 
inventory  as  of  the  first  day  and  as  of  the  last  day  of  each  taxa- 
ble year.  No  question  is  likely  to  be  raised  as  to  the  practice 
sometimes  prevailing  of  using  an  inventory  taken  not  on  the 
last  day  of  the  year,  but  for  convenience  on  the  nearest  Satur- 
day or  Sunday.  The  Treasury  has  ruled  that  a  taxpayer  who 
for  many  years  has  elected  to  take  inventory  only  every  two 
years  and  has  used  an  estimated  inventory  in  the  return  for 
the  intermediate  year,  may  not,  when  an  actual  inventory  was 

8  A.  R.  R.  249,  35-20-1168. 

»T.  B.  R.  48,  16-15^457;   Cum.  Bui.  1919  P-  47;  Sec.  212(a). 


taken,  apportion  his  total  earnings  for  the  two  years  equally 
between  such  years  for  income  tax  purposes.^®  It  is  not  per- 
missible to  have  one  period  for  taking  the  inventory  and  closing 
the  books  applicable  to  one  part  of  the  business  and  a  differ- 
ent period  for  another  part." 

Many  of  the  difficulties  in  the  use  of  inventories  spring  from 
the  fact  that  the  income  of  each  year  has  thus  to  be  set  off 
sharply  and  completely  from  that  of  each  succeeding  and  fol- 
lowing year.  With  varying  rates  of  tax  and  varying  profits, 
the  question  of  the  year  to  which  particular  profits  are  to  be 
allocated  is  often  of  great  consequence.  Inventory  difficulties 
would  be  lessened  by  using  as  a  basis  for  tax  computation  the 
average  income  for  a  period  of  years,  as  in  the  case  of  the  Brit- 
ish income  tax  on  trading  profits.  Even  though  the  report  of 
the  Royal  Commission  on  the  Income  Tax,  submitted  in 
March,  1920,  recommends  that  the  British  basis  be  changed  to 
that  of  the  profits  of  the  single  preceding  year,  on  the  ground 
that  under  the  present  system  the  adjustment  of  the  tax  lags 
too  far  behind  changes  in  income,  there  should  be  careful 
consideration  of  placing  in  our  law  provision  for  the  average 
basis.  Cleariy  the  provisions  permitting  a  net  loss  in  one  year 
to  be  applied  against  the  income  of  other  years  should  be 
extended  so  as  to  cover  all  years. 

How  Inventories  Must  Be  Taken 

Inventories  should  be  recorded  in  a  legible  manner  and  properly 
computed  and  summarized,  and  should  be  preserved  as  part  of  the 
accounting  records  of  the  taxpayer." 

On  the  actual  return  all  that  need  appear  is  a  summary  of  the 
inventory.  There  must  also  be  filed  with  the  return  a  "Cer- 
tificate of  Inventory"  (Form  1126),  setting  forth  under  oath 
the  basis  upon  which  the  inventory  was  taken,  the  names  of 
those  under  whose  direction  the  various  parts  were  taken,  and 
the  affidavit  of  such  persons  that  each  such  part  was  truly  arid 
completely  taken. 

"O.  D.  133,  4-iS^aii,  Cum.  Bui..  1919,  P.  63. 
"  O.  D.  289.  23-19-541.  Cum.  Bui..  1919,  p.  62. 
"Art.  1582. 


r 


f 


l:l( 


lit 


I 


l66      COLUMBIA     INCOME     TAX     LECTURES 

In  the  original  regulations,  it  was  stated  that  "a  physical 
inventory  is  at  all  times  preferred,  but  where  a  physical  inven- 
tory is  impossible  and  an  equivalent  inventory  is  equally 
accurate,  the  latter  will  be  acceptable.  An  equivalent  inven- 
tory is  an  inventory  of  materials,  supplies  and  merchandise  on 
hand  taken  from  the  books  of  the  corporation."  ^*  Since  the 
publication  of  these  original  regulations,  there  has  been  noth- 
ing set  forth  in  official  publications  as  to  the  method  of  the 
quantity  determination.  The  taxpayer  must  always  be  able  to 
show,  however,  that  the  inventory  is  accurate,  and  in  the  light 
of  experience  it  is  difficult  to  demonstrate  accuracy  except  in 
the  case  of  a  "physical  inventory;"  that  is,  an  actual  first-hand 
count  of  the  goods.  It  is  important  for  the  taxpayer  to  be 
able  to  show  that  the  count  was  made  by  such  persons  and  in 
such  a  way  as  to  be  reliable.  The  use  of  the  tag  system  helps 
the  proof  of  accuracy.  It  is  not  required  that  the  count  be 
made  all  on  any  one  day,  as  this  is  often  impossible.  In  some 
lines,  as,  for  example,  chain  stores,  inventories  are  successively 
taken  in  different  stores  by  a  trained  inventory  crew,  and  run- 
ning book  inventories  for  all  stores  checked  in  the  light  of 
frequent  physical  inventories,  are  reported  as  of  the  closing 
date.  Inventories  so  made  up  may  be  among  the  most 
accurate.  In  some  manufacturing  lines — as  in  certain  shoe 
factories — it  is  the  practice  at  the  end  of  the  "season's  run"  to 
close  successively  each  room  of  the  factory,  sending  forward 
for  the  next  process  all  possible  unfinished  stock,  so  that  in  the 
end  the  inventory  reported  consists  almost  entirely  of  raw 
materials  and  finished  goods.  Such  an  inventory,  while  most 
satisfactory,  is  not  strictly  as  of  the  closing  date;  the  new 
material  put  into  manufacture  after  the  inventory  process  is 
begun  being  under  this  system  treated  as  a  cash  advance  in 
respect  of  the  next  season. 

What  Is  to  be  Included  in  the  Inventory 

Except  in  the  case  of  dealers  in  securities,  business  inven- 
tories relate  to  physical  objects.     Incorporeal  assets,  such  as 

M  Reg.  33.  Art.  i6i. 


inventories 


167 


accounts,  bills  or  notes  receivable,  stock  or  bonds  are  listed 
at  cost  and  are  in  practice  never  referred  to  as  part  of  the 
inventory." 

In  the  field  of  physical  property,  the  fundamental  distinc- 
tion is,  of  course,  between  those  items  which  continue  service- 
able for  an  extended  period  and  are  classed  as  plant  or  equip- 
ment and  those  which  are  the  subject  of  constant  purchase  and 
sale,  such  as  raw  materials  and  finished  goods,  or  those  which 
have  constantly  to  be  replaced,  like  supplies.  A  certain 
limited  class  of  items  may  be  of  such  a  character  as  to  be 
capable  of  being  classed  either  as  part  of  the  inventory  or  as 
part  of  plant  and  equipment,  according  to  the  situation  and 
usages  of  the  particular  trade. 

Character  of  Items.  To  be  included  are  "raw  materials 
and  supplies  on  hand  that  have  been  acquired  for  sale,  con- 
sumption or  use  in  a  productive  process,  together  with  all 
finished  or  partly  finished  goods."  "  In  the  case  of  some  manu- 
facturing enterprises,  stock  in  process  was  wholly  or  partially 
omitted  from  the  inventory  or  put  in  at  a  figure  much  less 
than  cost  or  market,  on  the  theory  that  a  certain  quantity 
must  always  be  on  hand  and  is  never  sold.  Nothing  in  the 
regulations  sanctions  such  treatment.  If  the  taxpayer 
carries  materials  or  supplies  on  hand  for  which  no  record  of 
consumption  is  kept  or  of  which  inventories  at  the  beginning 
and  end  of  the  year  are  not  taken,  it  is  permissible  for  him 
to  include  in  his  expenses  the  cost  of  such  supplies  and  mate- 
rials as  are  purchased  during  the  year.  ^*  If,  however,  the 
amount  of  such  materials  and  supplies  is  large,  the  Commis- 
sioner will  presumably  require  that  they  be  handled  on  an 
inventory  basis. 

Scrap.  The  requirement  that  everything  on  hand  be  in- 
cluded does  not  mean  that  goods  have  to  be  listed  in  a  class 
to  which  they  may  have  originally  belonged,  but  to  which 
they  no  longer  belong.  Damaged  material,  trimmings, 
cuttings  and  the  like  which  have  lost  their  original  "new 

"  O.  D.  S4I,  34-20-994,  June  Cum.  Bui.,  p.  sa 

**  Art.  1581;  also  Art.  1584.  as  amended  by  T.  D.  3109. 

"  Art.  102,  p.  45;  Reg.  33  (Rev.),  Art.  13. 


I 


ii. 


m\i 


lie 


l68      COLUMBIA     INCOME     TAX     LECTURES 

materiar  form  may  be  taken  at  salvage  value  only  unless 
by  comparatively  small  expenditure  they  may  be  reworked 
so  as  to  be  suitable  for  manufacturing  purposes.  The  Treas- 
ury, however,  now  gives  very  restricted  scope  to  the  class 
of  scrap,  and  does  not  permit  finished  or  partly  finished  goods 
which  have  become  practically  unsaleable  to  be  treated  as 
scrap. 

Regulations  33  (Revised)  contains  a  provision  permitting  the 
making  of  proper  deductions  for  goods  which  "by  reason  of 
obsolesence  or  damage  are  unsaleable.^^  No  such  provision 
appears  in  the  present  regulations  and  the  Treasury  takes 
the  view,  although  no  ruling  on  the  point  has  been  published, 
that  the  former  provision  is  overruled  by  Article  162  of  Regu- 
lations 45,  which  states  that  depreciation,  including  obsoles- 
ence, "does  not  apply  to  inventories  or  stock  in  trade."  Reg- 
ulations 45  does  revoke  all  prior  regulations  which  are  incon- 
sistent therewith,  but  it  seems  clear  that  Article  160  of  Regu- 
lations 33  (Revised)  is  not  inconsistent  with  anything  in 
Article  162  of  Regulations  45,  or  elsewhere  in  the  regulations, 
and  that  the  Treasury's  present  attitude  on  this  point 
should  be  modified  so  as  to  give  recognition  to  the  "best 
accounting  practices"  in  various  trades  and  industries." 

"Depreciation,"  including  obsolescence,  is  an  allowance  for 
a  reserve  to  take  care  of  losses  reasonably  expected  to  result 
from  wear  and  tear  and  from  damages  in  the  arts.  It  applies 
only  to  plant  items,  not  at  all  to  stock  in  trade,  and  that  is  all 
that  Article  162  says  upon  the  point  here  involved.  In  the 
case  of  goods  which  have  become  damaged,  unsaleable,  or 
clearly  saleable  only  in  a  lower  class,  or  on  the  bargain  coun- 
ter, we  are  concerned  not  with  a  reserve  for  a  future  loss,  but 
with  mere  recognition  of  what  has  already  occurred.  No 
business  man  would  for  a  moment  be  excused  by  his  creditors 
or  stockholders  for  placing  such  goods  in  his  balance  sheet  at 
their  original  value,  nor  would  established  accounting  prac- 
tices sanction  such  conduct.  Nothing  in  the  law  prescribes 
such  a  practice.  The  implication  of  the  law  seems  contrary 
to  the  present  ruling  of  the  Treasury. 

»»  Art.  160. 


INVENTORIES 


169 


Every  taxpayer  should,  however,  take  particular  pains  to 
establish  and  record  the  facts  with  reference  to  all  merchan- 
dise treated  by  him  as  scrap,  unsaleable,  or  as  saleable  only 
at  great  sacrifice.  In  view  of  the  present  attitude  upon  the 
point  he  should  expressly  note  on  his  return  the  deductions 

so  claimed. 

Illustrating  the  contention  of  the  Treasury  upon  the  point 
above  discussed,  is  the  ruling  that  liquor  dealers  were  not 
allowed  to  leave  off  their  inventories  of  December  31,  1919, 
liquors  on  hand,  with  the  understanding  that  if  disposed  of 
for  value  the  total  receipts  would  be  turned  in  as  income.^' 
The  Committee  took  the  view  that  the  permission  of  the  use 
of  distilled  liquors  and  wines  for  medicinal  purposes  gave  some 
value  to  the  goods  on  hand  and  that  the  goods  should  be  inven- 
toried on  the  basis  of  such  value,  if  less  than  cost,  even  though 
the  entire  stock  could  not  have  been  disposed  of  at  any  one 
time  at  such  prices. 

Position  of  Items.  It  is  the  theory  of  the  Treasury  that  the 
taxpayer  must  include  in  his  inventory  all  goods  to  which  he 
has  title,  and  must  exclude  any  to  which  he  has  no  actual  title, 
regardless  of  the  taxpayer's  relation  to  the  goods  other  than 
the  relation  of  legal  ownership.  Thus,  goods  "sold"  but  not 
shipped  are  to  be  included  (although  they  cannot  be  taken  at 
less  than  cost).  Consigned  goods  are  to  be  included  in  the 
inventory  of  the  owner.  It  is  stated  that  consigned  goods  are 
not  to  be  included  in  the  inventory  if  they  have  been  reported 
as  sold,  but  it  is  difficult  to  see  how  consigned  goods  could  in 
any  case  be  properly  treated  as  sold.  Goods  to  which  the 
taxpayer  has  received  title  but  which  have  not  yet  been 
delivered  at  his  warehouse  are  to  be  included,  and  special 
caution  is  made  to  include  all  invoices  for  goods  in  transit. 

i«  A.  R.  M.  38,  13-20-804.  Cum.  Bui.  No.  2.  p.  54-  Some  practical  relief  on  thig  point. 
as  above  deacribed.  has  now  been  afforded  by  T.  D.  3109  issued  since  this  lecture  wai 
delivered  (Dec  13.  1920),  modifying  Art.  1584  as  amended  by  T.  D.  3047.  As  so  amended 
this  article  now  provides  that  where,  owing  to  abnormal  conditions,  the  taxpayer  has  regu- 
larly sold  merchandise  at  prices  less  than  replacement  cost,  he  may,  if  taking  inventory 
on  the  "cost  or  market,  whichever  is  lower*  basis,  value  the  goods  at  such  lower  prices, 
subject  to  check  in  the  light  of  his  actual  future  prices.  This  provision  affords  relief  in  the 
case  of  goods  which  have  lost  in  market  value,  but  in  terms  confines  relief  to  taxpayers 
fortunate  enough  "regularly  to  sell"  their  nearly  unmarketable  merchandise. 


I  ' 


I ;, 


170      COLUMBIA     INCOME     TAX     LECTURES 

In  view  of  the  stress  laid  on  title,  it  would  seem  that  goods 
shipped  sight  draft  against  bill  of  lading  might  not  be  included 
m  the  mventory  of  the  purchaser.^" 

A  striking  case  of  the  application  of  the  test  of  title  was 
presented  by  mining  companies  which  made  a  practice  of 
delivering  copper  bullion  to  a  smelting  and  refining  company, 
where  the  bullion  was  mixed  with  other  bullion  and  concen- 
trates of  different  metallic  content,  under  a  contract  by  which 
the  smelting  and  refining  company  was  to  return  the  equiva- 
lent of  the  metallic  content  of  the  ore,  less  commissions  and 
other  allowable  charges.    It  was  held  that  in  view  of  the  fact 
that  the  company  so  delivering  the  bullion  was  not  to  receive 
back  metal  made  from  the  bullion  so  delivered,  the  transaction 
constituted  a  sale  and  not  a  bailment,  and  that  the  mining 
company  should  not  include  in  its  own  inventory  any  bullion 
so  delivered  prior  to  the  close  of  the  taxable  year,  but  in 
respect  of  such  transactions,  should  include  only  so  much  of 
the  metals  as  has  been  delivered  by  the  refining  company 
against  the  obligations  arising  through  receipt  of  the  bullion  ^o 
''Shorr  Items.     It  was  held  by  the  Solicitor  that  where  a 
taxpayer  has  borrowed  stock  in  order  to  make  a  "short"  sale, 
the  gain  or  loss  arising  cannot  be  carried  on  his  books  (even 
though  he  be  a  dealer  in  securities)  at  the  close  of  his  taxable 
year  by  treating  as  an  offsetting  obligation  the  market  value 
of  the  stock  sold  "short"  as  of  that  day.^i    As  to  contract 
commitments,  it  has  been  ruled  by  the  Attorney  General,  sus- 
taining the  Treasury,  that  a  taxpayer  cannot  treat,  as  if  a 
part  of  his  inventory,  goods  which  he  had  contracted  to  pur- 
chase  but  which  had  not  been  delivered  before  the  dose  of 
the  year.    The  ground  of  the  opinions,  is  that  to  permit  the 
taking  into  accounts  mere  contract  requirements  would  be 
contrary  to  sound  accounting  practices  and  would  place  the 
income  statement  on  a  speculative  basis.    The  case  of  miscel- 
laneous merchandise  differs  from  that  of  stocks  in  that  stocks 
have  usually  a  more  cleariy  defined  market  value  and  in  that 

"Art.  1581. 

'•  S.  1373,  20-20-930.  Cum.  Bui.  No.  2,  p.  45. 

"  S.  1179,  24-19-558,  Cum.  Bui.,  1919.  p.  60. 


INVENTORIES 


171 


the  borrower  may  be  called  upon  at  any  time  for  their  return. 
A  late  ruling  of  the  Committee  of  Appeals  and  Review  applies 
the  principle  of  the  Attorney  General's  ruling  to  the  case  of 
cotton  and  grain  merchants  purchasing  or  selling  "futures" 
against  their  commitments  and  holds  that  the  "futures"  can 
not  be  included  in  the  inventory .22 

Valuation  Bases:  Cost  or  Market 

**Cost  or  Market,  Whichever  is  Lowers  This  general  rule 
first  promulgated  by  Treasury  Decision  2609  on  December  19, 
1917,  affirmed  by  T.  D.  2744  based  upon  an  opinion  of  the 
Attorney  General,  is  set  forth  in  Article  1582  as  the  funda- 
mental basis.  This  is  the  rule  recognized  in  Great  Britain. 
Before  December  19,  191 7,  the  single  basis  here  recognized  is 
supposed  to  have  been  cost,  although  that  basis  was  set  forth 
only  upon  the  corporation  form  appearing  in  October,  1916, 
(Form  1031)  and  never  in  a  Treasury  decision  or  ruling.  The 
basis  set  forth  in  Treasury  Decision  2609  represents  a  general 
conclusion  as  to  the  correct  method  of  computing  income,  and 
it  is  clear  that  the  Treasury  will  not  revise  returns  of  income 
for  191 7  or  prior  years  made  upon  the  inventory  basis  recog- 
nized as  correct  in  191 7. 

The  theory  of  taking  the  inventory  at  cost  is,  of  course, 
that  this  results  in  deducting  from  the  gross  proceeds  of 
goods  actually  sold  during  the  taxable  period,  the  exact  cost 
of  such  goods.  It  is  necessary,  in  order  to  accomplish  this 
result,  that  cost  of  goods  for  the  year  must  (i)  include  the  cost 
of  goods  carried  over  from  the  previous  period,  and  (2)  exclude 
the  cost  of  goods  carried  over  to  the  succeeding  taxable  period.*^ 
Inventories  taken  at  cost  seem  to  accomplish  precisely  this 
result.  Yet  if,  owing  to  changes  in  market  conditions,  the 
goods  to  be  carried  over  are  not  worth  the  cost,  it  is  clearly 
unjust  to  require  the  taxpayer  to  inventory  the  goods  at  cost. 
It  was  in  order  to  avoid  overstating  income  through  taking  the 

"T.  D.  3044;   30-20-1087;   T.  B.  R.  15.  S-19-251,  Cum.  Bui.  1919.  P-  I54;   A.  R.  M. 
100,  49-20-33 1  • 

*»T.  B.  R.  48.  16-19-1.  Cum.  Bui..  1919.  p.  47. 


i 


172       COLUMBIA     INCOME     TAX     LECTURES 

inventory  at  an  unduly  high  figure  that  business  men  worked 
out  the  basis  of  "cost  or  market,  whichever  is  lower."  As  to  the 
recognition  of  the  use  of  this  system  in  the  administration  of 
the  tax,  it  was  well  pointed  out  by  the  Advisory  Tax  Board 
that  while  profits  out  of  which  a  tax  is  to  be  taken,  must  be 
proved,  and  consist  only  of  actual  realizations,  losses  may  be 
properly  admitted}^  The  effect  of  admitting  losses,  even 
wrongly,  is  merely  to  postpone  profits  from  one  year  to  an- 
other, while  the  effect  of  failure  to  admit  them  is  to  treat  as 
income  that  which  is  really  capital. 

Where  "cost  or  market"  is  used,  it  applies  to  each  item  on  the 
inventory  and  not  to  the  inventory  as  a  whole.  The  taxpayer 
does  not  compute  the  entire  inventory  at  cost  and  also  at 
market  and  choose  the  lower,  but  takes  each  item  on  the  in- 
ventory and  prices  that  particular  item  at  cost  or  market, 
whichever  is  lower.  Where  a  taxpayer  is  using  this  alternative 
basis  he  must  show  both  cost  and  market  for  each  item  in  the 
inventory.  The  most  convenient  way  of  taking  the  inventory 
is  to  use  three  columns  opposite  each  item,  in  the  first  of  which 
is  recorded  cost,  in  the  second  market,  and  in  the  third  the 
lower  of  the  two.  The  total  of  column  3  is  the  figure  to  be 
used  in  the  inventory. 

In  the  case  of  commingled  goods,  whatever  basis  of  valuation 
is  being  used,  goods  which  cannot  be  identified  with  specific 
invoices  (or  with  a  specific  date  of  manufacture)  are  to  be 
deemed  the  most  recent  goods.»  Where  the  goods  can  be 
identified  with  specific  purchases,  the  actual  figures  would 
govern. 

Valuation  Bases:  Cost 

Goods  Purchased.  In  the  case  of  goods  purchased,  cost 
means  primarily  the  invoice  price.**  From  this  is  to  be  taken 
trade  or  other  discounts,  except  strictly  cash  discounts  approxi- 
mating a  fair  interest  rate.  Such  discounts  may  be  deducted 
or  not,  at  the  option  of  the  taxpayer,  provided  a  consistent 

»*  T.  B.  R.  48,  16-19-1,  Cum.  Bui.,  1919,  p.  47. 
"Art.  1582. 
■Art.  1583. 


inventories 


173 


course  is  followed.  It  was  held  by  the  Treasury  that  taxpayers 
who,  as  a  mattter  of  settled  practice,  do  not  deduct  cash  dis- 
counts from  purchases,  but  who  take  the  merchandise  pur- 
chased into  their  inventories  at  invoice  price  (less  trade  or 
other  discounts),  carrying  the  discounts  into  a  discount 
account,  may  not  in  valuing  their  closing  inventories  for  income 
tax  purposes,  deduct  from  the  invoice  price  of  the  merchandise 
the  average  amount  of  cash  discount  received  on  such  mer- 
chandise or  deduct  from  the  discount  earned  an  amount  repre- 
senting the  estimated  cash  discount  received  on  the  merchan- 
dise on  hand  at  the  close  of  the  year." 

To  the  invoice  price  is  to  be  added  transportation  or  other 
necessary  charges  incurred  in  acquiring  possession  of  the  goods. 
This  would  include  not  only  railroad  or  steamship  charges,  but 
trucking  charges,  where  it  is  possible  to  ascertain  them.  Such 
charge  may  also  include  customs  duties  and  specific  taxes,  like 
sales  taxes  or  excise  taxes,  as  in  the  case  of  liquors  or  tobacco. 
A  taxpayer  is  not  permitted,  however,  to  change  at  his  election 
a  practice  once  established  with  reference  to  the  treatment  of 
such  items.** 

The  regulations  do  not  require,  however,  that  any  part  of 
the  overhead  for  the  year  be  assigned  as  part  of  the  cost  of 
goods  purchased. 

Cost:  Goods  Manufactured  or  Processed.  In  the  case  of  goods 
manufactured,  cost  is  to  include: 

a.  "The  cost  of  the  raw  materials  and  supplies  entering  into 
or  consumed  in  connection  with  the  product;" 

h.   "Expenditures  for  direct  labor;"   and 

c.  "Indirect  expenses  incident  to  and  necessary  for  the 
production  of  the  particular  article  including  in  such  indirect 
expenses  a  reasonable  proportion  of  management  expense,  but 
not  including  any  cost  of  selling  or  return  on  capital,  whether 
by  way  of  interest  or  profit." 

The  proper  course  with  reference  to  adding  overhead  expense 
to  stock  in  process  is  not  free  from  doubt.  While  logically  such 
costs  might  well  be  added,  practically  it  is  often  very  difficult 

"  O.  D.  326,  18-19-610.  Cum.  Bui.,  1919.  p.  56. 

"Art.  132:  Reg.  33  (Rev.).  Art.  i9S;  O.  D.  137,  4-i9-ai6. 


i(i 


I 

t 


!    1 


K 


'Mil! 


I 


174      COLUMBIA     INCOME     TAX     LECTURES 

to  allocate  them  except  on  the  basis  of  completed  articles. 
However,  Treasury  Decision  3109,  recently  issued,  insists 
that  account  be  taken  of  burden  in  determining  the  cost  of 
stock  in  process. 

The  specification  of  what  is  to  be  included  seems  to  rule  out 
any  charge  for  interest  or  for  rent  or  for  "idle  time"  of  ma- 
chines, all  of  which  are  often  reflected  by  cost  systems. 

How  Cost  Is  to  be  Determined.  While  it  is  easy  to  say  what 
items  are  to  be  included  in  cost,  it  is  in  practice  very  difficult 
to  get  at  the  amounts  for  each  item  which  are  to  be  allocated 
to  various  items  in  the  inventory.  It  is  accordingly  recognized 
by  the  Treasury  that  what  must  very  often  be  used  is  estimated 
cost.  The  statement  in  the  regulations  on  this  point  is  not 
particularly  clear,  but  the  Solicitor  has  ruled : 

It  is  recognized  in  some  industries  the  actual  cost  of  production  can- 
not be  ascertained  accurately,  and  it  is  therefore  necessary  to  approxi- 
mate a  cost  value  by  using  selling  market  prices  as  a  starting  point 
and  reducing  such  selling  market  prices  in  each  case  by  an  amount 
sufficient  to  eliminate  the  element  of  profit.  This  rule  is  applicable  to 
the  inventories  of  farmers  and  stock  men,  and  is  widely  used  in  many 
lines  of  industry,  notably  in  those  types  of  mining  and  manufacture 
in  which  a  product  of  more  than  one  grade  is  obtained  by  a  common 
operation.  Under  its  application  a  result  can  be  reached  that  fairly 
approximates  the  inventory  basis  laid  down  in  the  regulations.* 

Even  when  cost  is  built  up,  instead  of  reckoned  back,  aver- 
ages and  apportionments  must  frequently  be  used.  It  may 
fairly  be  said  that  in  most  cases,  where  manufacture  is  in- 
volved, "cost"  is  in  fact  the  best  practicable  estimate,  based 
upon  actual  figures  wherever  available.  Special  cost  problems 
arise  where  the  factory  is  not  operated  at  full  capacity.  It 
would  seem  that  in  such  cases  the  full  overhead  expense  should 
not  be  apportioned. 

The  cost  basis  now  carefully  prescribed  for  retail  drygoods 
dealers  is  a  specific  application  of  this  estimating  method.  Un- 
der it  the  cost  of  the  inventory  is  permitted  to  be  computed  by 
taking  the  selling  price  and  deducting  the  amount  of  the  aver- 
age mark-up,  careful  allowance  being  made  for  all  special 
mark-down  sales. ^° 

«•  O.  844,  6-19-268,  Cum.  Bui.,  1919.  p.  59;    O.  D.  25.  1-19-370.  Cum.  Bui.  1919.  p.  75. 
w  Art.  1588,  T.  D.  3058,  35-20-1162. 


INVENTORIES 


175 


Cost  Systems.  Cost  systems  are  not  in  use  in  most  cases. 
They  are  often  difficult  of  application,  and  no  ruling  has  been 
made  prescribing  their  use.  In  cases  in  which  the  inventory 
is  priced  according  to  the  results  of  the  cost  system,  the  tax 
payer  must  be  in  a  position  to  show  how  the  operation  of  the 
system  ties  in  with  the  books  of  account,  that  is,  how  all  actual 
expense  is  allocated,  how  the  previous  inventory  is  taken  up, 
etc.  Certain  cost  systems  treat  as  an  element  of  cost  items 
like  interest  which  are  not  required  or  permitted  by  the 
regulations  to  be  so  treated,  and  corrections  would  have  to  be 
made  to  exclude  such  items. 

Basis  OF  Valuation:  Market 

To  What  Items  It  Applies.  The  regulations  do  not  permit 
the  market  alternative  to  be  applied  to  "goods  on  hand  or  in 
process  of  manufacture  for  delivery  upon  firm  sales  contracts 
at  fixed  prices  entered  into  before  the  date  of  the  inventory, 
which  goods  must  be  inventoried  at  cost".'^  The  idea  under- 
lying the  permitted  use  of  the  market  alternative  is  thus  to 
permit  only  the  reflecting  of  loss  that  seems  certain.  There  is 
much  practical  difficulty  in  applying  the  "firm  contract"  limita- 
tion. It  is  often  very  difficult  to  tell  what  goods,  except  dis- 
tinctively finished  goods,  apply  against  the  contract.  It  is 
also  very  difficult,  particularly  in  these  times,  to  tell  what  is  a 
firm  contract.  Certainly  a  contract  which  has  been  repudi- 
ated, or  upon  which  the  delivery  of  goods  has  been  refused, 
should  not  be  treated  as  firm.  And  if  the  price  specified  in  the 
contract  is  itself  less  than  cost,  it  should  be  permissible  to  value 
the  goods  applying  to  that  contract  at  that  price,  instead 
of  cost.  Except  for  goods  applying  to  firm  contracts  the  al- 
ternative applies  to  all  items  in  the  inventory. 

"Market"  Interpreted  as  Replacement  Cost.  "Market"  is  de- 
scribed in  the  regulations  as  meaning  "the  current  bid  price 
prevailing  at  the  time  of  the  inventory."  '^  It  is  not  treated  by 
the  Treasury  as  meaning  merely  a  price  which  in  the  judg- 
ment of  the  taxpayer  is  fair  and  reasonable.     The  regulations 

»'  Art.  1584,  Rev.  T.  D.  3047. 
«  Art.  1584. 


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176      COLUMBIA     INCOME     TAX     LECTURES 

do  not  Specify  whether  the  prices  to  be  followed  are  those  for 
the  finished  articles  turned  out  by  the  factory,  or  those  in- 
volved in  the  items  entering  into  those  articles,  t.e.,  prices  in 
the  selling  market,  or  prices  in  the  purchasing  market.  In 
connection  with  this,  however,  consult  footnote  33,  below.  In 
practice,  the  Treasury  appears  to  regard  as  "market"  solely 
the  cost  of  replacement  of  the  goods  by  the  taxpayer  as  to  the 
date  of  the  inventory.  In  the  case  of  goods  on  hand  in  their 
original  form,  the  actual  replacement  quotation  can  be  used. 
In  the  case  of  goods  wholly  or  partly  manufactured,  the  market 
quotation  or  "current  bid  price"  which  is  to  be  used  is  that  for 
the  raw  materials  in  the  goods  on  hand.  If  the  constituent 
materials  of  the  wholly  or  partially  finished  stock  are  at  the 
date  of  the  inventory  quoted  at  less  than  their  actual  cost, 
there  can  be  taken  out  of  the  inventory  the  difference  between 
that  actual  cost  and  their  replacement  cost.  The  Treasury 
has  not  recognized,  however,  any  right  to  take  a  deduction,  in 
making  this  re-estimate,  for  a  reduction  in  the  cost  of  labor,  or 
in  the  cost  of  manufacture  due  to  the  use  of  an  improved  pro- 
cess. Logically,  however,  such  reductions  should  also  be  al- 
lowed where  they  can  be  clearly  shown  to  apply  to  the  replace- 
ment oiF  any  item  in  the  inventory,  and  if  the  selling  value  of 
the  finished  goods,  as  determined  on  the  market  for  such  goods, 
is  less  than  their  cost,  clearly  this  value  should  be  permitted  to 
be  used.  In  such  a  case  the  selling  value  of  the  goods  would 
be  such  as  to  prevent  any  profit  whatever.  No  sound  reason 
appears  for  limiting  the  scope  of  market  to  the  replacement 
market,  and  ignoring  the  selling  market." 

Seconds.  In  certain  lines  of  manufacture  there  is  normally  a 
considerable  production  of  goods  which  are  defective,  but 
nevertheless  merchantable.    Where  it  can  be  shown  that  these 

•»  A  very  important  Treasury  Decition.  3109,  issued  after  this  lecture  was  delivered, 
amends  Article  1584  and  makes  it  now  conform  in  part  to  the  positions  advocated  in  the 
above  discussion:  (i)  It  is  now  clear  that  in  making  the  replacement  cost  estimate,  all 
changes  in  elements  of  cost  are  to  be  considered,  i.  e.,  labor  and  burden  as  well  as  cost  of 
raw  materials.  (3)  It  is  conceded  that  the  price  taken  from  the  selling  market  may  in  some 
cases  be  used  instead  of  that  of  the  replacement  market.  This  selling  price  is  only  to  be 
used  where,  owing  to  abnormal  conditions,  the  taxpayer  has  regularly  sold  goods  at  less 
than  replacement  cost  and  its  use  is  subject  to  check  in  the  light  of  the  prices  to  which  the 
taxpayer  actually  does  sell  after  the  date  of  the  inventory.  This  decision  also  covers  clearly 
for  the  first  time  the  treatment  of  stock  in  process. 


INVENTORIES 


177 


inferior  goods— often  called  "seconds"— usually  sell  at  some 
definite  percentage  less  than  the  standard  article,  and  the 
market  alternative  is  used,  it  would  seem  to  be  proper  to  take 
this  reduction  in  pricing  the  "seconds"  included  in  the  inven- 
tory. The  "market"  provision  does  not,  however,  justify  the 
pricing  of  inferior  goods  at  merely  arbitrary  or  ultra-conserva- 
tive figures. 

Proof  of  Market  Price.  The  ordinary  method  of  proof  is  by 
"open  market  quotation,"  but  the  burden  of  proof  rests  upon 
the  taxpayer  in  each  case  to  satisfy  the  Commissioner  of  the 
correctness  of  the  prices  adopted.  The  taxpayer  must,  there- 
fore, be  in  a  position  to  show  that  market  prices  represent  bona 
fide  transactions  in  a  free  market  in  sufficient  volume  to  furnish 
real  evidence.  Collusive  or  colorable  sales  would  not  be  ac- 
cepted as  establishing  market."  Where  no  open  market  quota- 
tions are  available,  the  taxpayer  is  permitted  to  use  "such  evi- 
dence of  a  fair  market  price  at  the  date  or  dates  nearest  the 
inventory  as  may  be  available,  such  as  specific  private  transac- 
tions in  reasonable  volume  entered  into  in  good  faith,  or  com- 
pensation paid  for  the  cancellation  of  contracts  for  purchased 
commitments."  The  evidence  which  may  be  so  used  may  relate 
to  a  period  after,  although  near,  the  close  of  the  tax  year.  It  is 
not  settled  how  late  the  period  may  be,  but  the  object  always 
is  to  get  at  the  market  situation  as  it  probably  was  on  the 
closing  date.  Questions  of  difficulty  arise  where  the  market 
from  which  quotations  must  be  taken  are  at  a  distance  from 
the  taxpayer's  plant. 

Government  Prices  at  the  Close  of  1918.  The  regulations 
(Article  1584)  provide  as  follows: 

It  is  recognized  that  in  the  latter  part  of  1918,  by  reason  among 
other  things  of  governmental  control  not  having  been  relinquished, 
conditions  were  abnormal  and  in  many  commodities  there  was  no 
such  scale  of  trading  as  to  establish  a  free  market.  In  such  a  case 
where  a  market  has  been  established  during  the  succeeding  year  a 
claim  may  be  filed  for  any  loss  sustained  in  accordance  with  the 
provisions  of  section  214  (a)  (12). 

A  more  just  ruling  applicable  to  the  situation  thus  cleariy 
recognized  by  the  Treasury  would  be  to  permit  the  reporting 

•*Art  1584.  amended  by  T.  D.  3109* 


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178       COLUMBIA     INCOME     TAX. LECTURES 

of  inventories  as  of  the  close  of  191 8  on  the  basis  of  the  prices 
established  by  the  first  free  market  in  191 9,  instead  of  merely 
permitting  the  filing  of  an  inventory  loss  claim.  The  taxpayer 
should  not  be  denied  the  benefit  of  valuing  at  market  his  clos- 
ing inventory  for  191 8,  even  though  by  reason  of  the  continu- 
ance of  the  nominal  Government  prices  there  were  at  the  mo- 
ment no  actual  market  transactions.  The  Government  prices 
in  many  cases  meant  nothing,  because  no  goods  were  then 
bought  or  sold  at  such  prices.  The  prices  established  on  the 
first  market  subsequent  to  the  removal  of  the  restrictions  do 
not  indicate  a  reduction  of  the  value  of  the  inventory  subse- 
quent to  the  close  of  191 8,  but  rather  indicate  the  actual  facts 
as  to  the  values  which  existed  at  the  close  of  that  year.  The 
use  of  such  prices  in  computing  the  closing  inventory  seems 
necessary  in  order  to  reflect  the  true  income  for  191 8. 


Other  Permitted  Bases  of  Valuation 

Farmers  and  Growers  of  Live  Stock:  Market.  The  Treasury 
recognizes  the  logic  of  the  facts  and  rules  that : 

Because  of  the  impracticability  of  identifying  livestock  purchased 
and  livestock  raised,  and  the  difficulty  of  ascertaining  the  actual  cost 
of  livestock  and  other  farm  products  raised,  farmers  who  render  their 
return  upon  an  accrual  basis  may,  at  their  option,  value  their  inven- 
tories for  the  taxable  year  according  to  the /arm  price  method,  which 
contemplates  a  valuation  of  inventories  at  market  prices  less  cost 
of  marketing.^^ 

The  basis  here  permitted  for  agricultural  operations  is  not  that 
of  cost  or  market,  but  of  plain  market.  Farmers  first  changing 
over  to  the  "farm  price"  basis  are  required  to  treat  as  their  open- 
ing inventory  the  inventory  which  was  used  for  the  close  of  the 
previous  year,  but  they  may  revise  their  previous  years' 
returns  so  as  to  place  them  upon  the  "farm  price"  basis  if  the 
income  for  the  year  of  the  change  otherwise  made  is  abnor- 
mally large.^*  This  "farm  price"  inventory  basis  applies  to  all 
agricultural  operations,  like    tobacco  culture  or  the  raising 

"Art.  isSsa.  T.  D.  3011,  18-20-18,  Cum.  Bui.  No.  a,  p.  57;   A.  R.  R.  14,  »-3<HMS. 
ibid.,  p.  56.    Cf.  Art.  1585a,  amended,  T.  D.  3104. 
••  O.  D.  481,  18-20-893,  Cum.  Bui.  No.  2.  p.  66. 


inventories 


179 


of  raw  sugar,  and  will  undoubtedly  be  accepted  for  the  prior 
year  as  well  as  for  the  current  year. 

Lumber  Manufacturers.  A  recent  treasury  decision  pro- 
vides that  in  the  case  of  those  who  manufacture  lumber  from 
logs,  in  view  of  the  impracticability  of  determining  accurately 
the  costs  properly  assignable  to  each  grade  and  dimension  of 
lumber  making  up  the  product  of  the  mill,  the  taxpayer  may 
use  as  a  basis  for  price  inventory,  the  average  cost  to  the  manu- 
facturer of  producing  the  various  products  during  the  whole 
of  the  taxable  year;  also  that  if  the  taxpayer  regularly  allocates 
in  his  books  of  account  such  average  cost  to  the  different  kinds 
and  grades  of  lumber  in  proportion  to  their  selling  value,  a 
return  upon  this  basis  will  be  accepted.*' 

Tobacco  Companies:  Average  Cost.  It  was  finally  ruled  by 
the  Bureau  that  "tobacco  companies  taking  inventory  on  the 
monthly  average  cost  method,  no  method  more  nearly  ap- 
proaching theoretical  accuracy  being  practically  possible, 
may  continue  such  method  in  reporting  for  income  tax."  This 
is  a  partial  reversal  of  the  general  ruling  of  the  Advisory  Tax 
Board  excluding  the  average  cost  method.'* 

Under  this  method  the  materials  purchased  during  the 
month,  both  as  to  quantity  and  cost,  are  added  to  the  quantity 
and  cost  brought  forward  from  the  previous  month  and  the 
average  cost  at  the  close  of  the  month  is  computed  by  dividing 
the  total  quantity  by  the  money  figures,  this  average  being 
applied  to  the  quantity  of  materials  used  in  the  month  and  the 
net  balance  carried  forward  to  the  next  month.  This  basis  was 
disapproved  by  the  Advisory  Tax  Board  as  not  representing 
the  actual  costs  for  the  taxable  year,  but  was  approved  by  the 
present  Committee  on  Appeals  and  Review  on  account  of  its 
wide  use  in  the  industry  and  because  under  the  peculiar  con- 
ditions of  the  industry  the  application  of  ordinary  methods 
for  valuing  the  inventory  did  not  appear  to  be  practicable. 

Change  In  Inventory  Basis 
A  taxpayer  who  has  elected  to  take  his  inventories  upon  a 
particular  authorized  basis,  which  must  be  indicated  in  his 

»^  Art.  1585b,  T.  D.  3024,  24-30-995,  Cum.  Bui.  No.  2,  p.  57- 

»» A.  R.  R.  18.  3-20-680.  Cum.  Bui.  No.  2,  p.  50;  T.  B.  R.  48.  ibid.,  1919.  P-  47. 


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l80      COLUMBIA     INCOME     TAX     LECTURES 


INVENTORIES 


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returns,  cannot  change  from  that  basis  without  approval 
of  the  Commissioner.  In  the  case  of  a  shift  from  cost  to  "cost 
or  market,  whichever  is  lower,"  no  such  express  provision  was, 
however,  required  for  returns  filed  for  the  year  191 8,  provided 
the  newly  adopted  basis  was  indicated  on  the  return.  As  to 
years  subsequent  to  19 19  it  was  ruled  that  the  taxpayer  would 
not  be  permitted  to  change  his  basis  of  valuation  where  it 
appeared  that  the  object  of  the  change  was  to  reduce  tax 
liability.  It  is  now  ruled,  however,  that  a  taxpayer  will  be 
permitted  for  the  present  year  to  change  from  cost  to  "cost  or 
market,  whichever  is  lower,"  provided  it  is  established  that 
market  at  the  close  of  19 18  and  1919  was  higher  than  cost.** 
Any  taxpayer  desiring  to  make  this  change  must,  however, 
secure  from  the  Commissioner  written  permission,  based  upon 
an  application  accompanied  by  satisfactory  affidavits  showing 
that  at  the  periods  indicated  market  was  above  cost. 

Many  taxpayers  have  been  required  by  the  regulations 
to  shift  from  a  basis  by  which  inventories  were  valued  low 
to  one  upon  which  higher  valuations  are  used.  Where  such 
a  shift  is  made  at  the  end  of  any  year  the  income  for  that  year 
is  unduly  increased,  unless  there  is  a  corresponding  revalua- 
tion of  the  opening  inventory,  and  as  such  a  revaluation  is 
accordingly  in  order.  Such  a  change  ordinarily  involves 
recomputation  of  income  for  prior  years,  based  upon  proper 
adjustment  of  the  inventories.  Where  the  change  in  the 
inventory  basis  is  not  from  an  unauthorized  to  a  proper  basis, 
but  from  one  authorized  basis  to  another,  as  in  the  case  of  a 
shift  from  cost  to  "cost  or  market,  whichever  is  lower"  no  ruling 
calls  for  or  permits  any  change  in  the  opening  inventory  or  in 
the  returns  for  prior  years. *°  In  the  case  of  farmers  changing  from 
cost  to  the  market  basis  an  exception  has  been  made  permitting 
the  use  of  an  opening  inventory  on  the  market  basis  and 
adjustment  of  the  returns  from  191 7  on  upon  the  same  basis. 

"A.  R.  M.  85,  43-20-1273;  Art.  23  (Rev.),  T.  D.  2873;  A.  R.  M.  38,  X3-20-804- 
A  late  treasury  decision,  3108,  amends  Article  1582  to  provide  that  a  taxpayer  may, 
regardless  of  his  past  practice,  adopt  the  cost  or  market  basis  for  1920,  provided  a  disclosure 
of  the  change  is  made  upon  the  return.  This  does  away  with  the  necessity  for  securing  the 
approval  of  the  Commissioner  in  each  case,  and  also  for  showing  that  cost  was  below  the 
market  at  the  end  of  1918  and  at  the  end  of  1919. 

«•  A.  R.  M.  38,  13-20-804. 


Bases  of  Valuation  Not  Permitted 

Market.  This  basis  is  not  permitted  except  (i)  in  the  case  of 
agricultural  enterprises  and  (2),  for  constitutional  reasons, 
in  the  case  of  goods  on  hand  March  i,  IQ13.  In  general  ac- 
counting practice  its  use  is  not  sanctioned  because  it  involves 
taking  into  account  gains  merely  anticipated. 

Average  Cost.*^  Any  average-cost  basis  involving  the  use 
of  costs  in  prior  years  has  not  been  approved,  except  in  the 
case  of  tobacco  growers  and  to  a  limited  extent  in  the  case 
of  lumber  manufacturers.  The  ground  given  by  the  Advisory 
Tax  Board  for  the  disapproval  of  this  basis  was  that  its  use 
is  not  consistent  with  the  requirement  that  the  gains  and  losses 
of  each  taxable  year  be  separately  computed.*^  It  was  also 
suggested  that  if  costs  were  to  be  averaged  on  a  basis  taking 
in  prior  years,  then  logically  sales  or  receipts  should  be  simi- 
larly averaged.  In  other  industries  besides  tobacco,  this 
method  has  undoubtedly  been  found  the  most  practicable, 
and  it  is  difficult  to  see  how  its  use,  approved  in  one  industry, 
can  be  disapproved  in  any  others  in  which  it  is  similarly 

established. 

The  Base-Stock  Method.  The  use  of  the  "base-stock,"  "mini- 
mum" or  "cushion"  method  of  taking  inventories  was  disap- 
proved by  the  Advisory  Tax  Board  in  a  carefully  considered 
opinion.**  According  to  this  method  a  manufacturer  or  dealer 
values  at  the  same  price  year  after  year  the  minimum  quantity 
of  goods  which  he  must  have  on  hand  at  all  times.  The  grounds 
for  the  rejection  of  the  use  of  this  method  were  (a)  that  the 
practice  was  not  in  fact  widely  established;  {b)  that  income 
computations  on  this  basis  were  not  accurate,  in  that  it 
"ignores  quasi  capital  gains  for  motives  of  prudence";  (c)  that 
it  was  extremely  difficult  to  determine  a  satisfactory  base 
price  and  base  quantity. 

If  the  use  of  this  method  were  established  in  the  case  of 
any  business  there  would  be  much  to  say  in  justification  of 
returns  of  income  computed  upon  this  basis.    It  is  an  almost 

♦•  Form  H26. 

«T.  B.  M.  31,  i6-is^i.  Cum.  Bui.,  1919.  P.  SS- 

«T.  B.  R.  6s,  19-22-S,  Cum.  Bui.  1919.  P-  Si. 


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l82       COLUMBIA     INCOME     TAX     LECTURES 

universal  experience  that  supposed  profits  have  consisted 
largely  in  mere  replacement  of  inventory  at  higher  prices, 
and  have  vanished  when  prices  receded.  The  base-stock 
method  of  taking  inventories  prevents  the  reporting  of  such 
illusory  profits.  If  a  case  arises  in  which  this  basis  has  been 
consistently  used,  it  would  seem  advisable  again  to  press  the 
question  before  the  Treasury.  A  difficulty  of  securing 
approval  of  the  method  is  that  of  so  formulating  it  that  it 
may  be  made  scientific  and  generally  applicable. 

Inventory  Reserves  Not  Permitted  as  Deductions 

The  regulations  do  not  permit  any  deductions  from  inven- 
tory to  offset  possible  future  losses  or  to  place  the  computation 
upon  a  conservative  basis.  This  has  been  clear  since  Decem- 
ber, 1917,  if  not  since  October,  1916,  and  the  Treasury 
rigorously  corrects  returns  of  income  computed  upon  the 
basis  of  such  deductions  from  inventory.  The  wider  knowl- 
edge of  the  disallowance  of  such  reserves  and  the  desire  to 
recompute  surplus  so  as  to  secure  a  full  allowance  of  invested 
capital  had  led  to  many  voluntary  corrections  by  taxpayers  of 
income  returns  for  eariy  years,  based  on  computations  in- 
volving flat  cuts  from  the  inventory. 

It  has  been  urged  that  where  it  has  been  the  practice  to 
make  deductions  so  as  to  place  the  inventory  at  a  safe  figure, 
such  deductions  should  be  permitted  to  stand  in  the  compu- 
tation of  taxable  income.  It  cannot  be  denied  that  con- 
servatism in  the  determination  of  business  income  benefits 
the  public  through  promoting  economic  stability,  or  that 
taxing  the  full  amount  of  income  which  may  be  offset  by 
inventory  losses  is  harsh,  if  not  unjust.  It  is,  however,  im- 
possible fairly  to  administer  the  tax  law  unless  income  is  com- 
puted upon  the  basis  of  inventories  taken  according  to  estab- 
lished methods  equally  available  to  all.  For  the  Treasury 
to  pass  satisfactorily  upon  the  propriety  of  inventory  reserves, 
to  cover  possible  shrinkage,  is  difficult  if  not  impossible.  It 
cannot  be  claimed  that  any  basis  has  yet  been  formulated  by 
accountants  for  the  systematic  making  and  handling  of  such 


inventories 


183 


reserves.  In  the  present  situation  the  Treasury  can  hardly 
do  otherwise  than  decline  to  admit  them  as  deductions  from 
income.  Constructive  work  by  business  men  and  accountants 
might  lead  to  the  establishment  of  scientific  reserve  methods 
for  different  industries,  the  open  use  of  which  would  promote 
security  and  prevent  imposition  of  tax  upon  merely  paper 
profits.  With  such  methods  definitely  worked  out,  their 
approval  by  the  Treasury  would  be  in  line  with  the  intent 
and  provisions  of  the  law.  Until  such  methods  are  worked 
out,  inventory  reserves  will  undoubtedly  continue  to  be 
treated  as  made  from  net  profits  rather  than  from  gross 


income. 


Inventory  Losses 


The  inventory  loss  provision  of  the  Revenue  Act  of  191 8, 
upon  which  taxpayers  at  first  placed  much  reliance,  has  so 
far  yielded  very  little  relief.  This  is  partly  because  the  in- 
ventory shrinkage  expected  in  191 9  did  not  develop,  and 
partly  because  of  the  limitations  placed  on  the  scope  of  that 
section  in  the  interpretation  by  the  Treasury.  The  section 
provides  in  substance  as  follows: 

Section  214  (a)  12. 

a.  At  the  time  of  filing  return  for  the  taxable  year  1918  a  taxpayer 
may  file  a  claim  in  abatement  based  on  the  fact  that  he  has  sustamed 
a  substantial  loss  (whether  or  not  actually  realized  by  sale  or  other 
disposition)  resulting  from  any  material  reduction  (not  due  to  tem- 
porary fluctuation)  of  the  value  of  the  inventory  for  such  taxable 
year.  .  .  If  it  is  shown  to  the  satisfaction  of  the  Commissioner  that 
such  substantial  loss  has  been  sustained,  then  in  computing  the  tax 
imposed  by  this  tide,  the  amount  of  such  loss  shall  be  deducted  from 

the  net  income.  .  r      •        r   . 

6.  If  no  such  claim  is  filed,  but  it  is  shown  to  the  satisfaction  of  the 
Commissioner  that  during  the  year  1919  the  taxpayer  has  sustained  a 
substantial  loss  of  the  character  above  described,  then  the  amount  of 
such  loss  shall  be  deducted  from  the  net  income  for  the  taxable  year  of 
1918  and  the  tax  imposed  by  this  title  for  such  year  shall  be  redeter- 
mined accordingly.     .     . 

In  the  case  of  any  claim  for  abatement  the  claim  must  be 
accompanied  by  a  surety  bond  and  if  the  claim  is  disallowed, 
interest  on  the  amount  of  the  tax  unpaid  by  reason  of  the  claim 
is  assessed  at  one  per  cent,  a  month.** 

**  Art.  266. 


'\ 


' 


'1 

i 


t 


l84      COLUMBIA     INCOME     TAX     LECTURES 

Limitations  which   operate   to  deprive   this  provision   of 
practical  effect  include  the  following: 

I.  The  provision  in  its  terms  applies  only  to  readjustments 
for  the  taxable  year  1918,  due  to  changes  in  inventory  during 
1919.  The  only  possible  justification  for  this  time  limitation 
was  that  extraordinary  conditions  might  develop  in  1919, 
which  would  not  be  expected  to  recur  in  later  years.  The 
expected  after- the- war  slump  did  not  come  until  1920.  Every 
consideration  which  led  to  the  placing  of  such  a  provision  in 
the  1918  Act  ought  to  lead  to  an  amendment  making  the 
provision  effective  for  the  year  1919  and  also  available  to 
take  care  of  violent  price  fluctuations  in  later  years. 

2.  The  Treasury  has  treated  "loss"  as  used  in  this  provi- 
sion as  meaning  a  net  loss  upon  the  closing  inventory  for  19 18 
as  a  whole.-*^  Under  its  rulings  any  gains  realized  in  1919 
through  the  sale  of  part  of  the  opening  inventory  are  to  be 
offset  against  shrinkages  on  other  parts  of  the  inventory.  In 
order  to  determine  whether  or  not  there  has  been  such  a  loss 
on  the  inventory  as  a  whole,  disposition  of  claims  is  postponed 
until  after  the  close  of  the  year  1919  and  goods  still  on  hand 
after  the  1918  inventory  are  to  be  taken  at  their  then  market 
price  if  less  than  cost.  In  determining  whether  1918  goods 
are  then  on  hand,  the  presumption  is  applied  that  sales 
are  satisfied,  as  they  are  made,  from  the  goods  longest  on 
hand.*^ 

A  ruling  more  consistent  with  the  apparent  purpose  of  the 
section  would  be  that  loss  is  allowed  in  respect  to  any  items  in 
the  inventory  which  show  a  shrinkage,  regardless  of  profits 
on  other  items.  What  led  to  the  adoption  of  the  provision  was 
the  earnest  insistence  of  business  men  that  some  plan  be  fol- 
lowed which  would  prevent  the  exaggeration  of  the  profits  of 
1918  through  the  enforced  taking  of  inventories  at  figures 
which  in  many  instances  would  prove  to  be  too  high.  The 
theory  of  the  inventory  loss  section  adopted  in  recognition  of 
this  just  demand  seems  to  be  that  the  closing  inventory  for 

«  Art.  267.  T.  B.  M.  52.  Cum.  Bui..  1919.  p.  ISS:   O.  D.  186.  8-19-323,  Cum.  Bui., 
1919.  p.  I54< 

*•  Art.  263,  267. 


INVENTORIES 


185 


191 8  could  be  refigured  in  the  light  of  the  actual  market  devel- 
opments of  19 19.  If  at  the  close  of  191 8  the  market  value  of 
particular  goods  in  the  inventory  had  already  fallen  off,  those 
goods  could  have  been  inventoried  on  the  basis  of  this  lower 
price  (if  less  than  cost)  notwithstanding  the  fact  that  other 
goods  in  the  inventory  showed  a  market  price  higher  than  cost. 
The  inventory  loss  section  should  be  given  the  effect  of  pro- 
longing the  period  on  the  basis  of  which  the  inventory  is  to 
be  computed,  but  not  the  effect  of  applying  profits  realized  in 

1 91 9  on  the  disposition  of  articles  against  shrinkages  on  other 
articles.  Such  shrinkages  are  by  law  permitted  to  be  taken  as 
applying  to  191 8.  Nothing  requires  the  relating  back  to  1918 
of  gains  made  in  19 19.  The  inventory  loss  section,  like  the 
"cost  or  market"  provision,  should  be  interpreted  as  applying 
to  those  items  of  the  inventory  on  which,  in  the  sense  of  the 
statute,  there  is  a  loss,  and  not  to  the  inventory  as  a  whole. 

3.  It  was  ruled  by  the  Treasury  that  the  loss  to  be  al- 
lowed on  goods  sold  is  only  to  "the  amount  by  which  the  value 
at  which  the  goods  sold  were  included  in  the  inventory  exceeds 
the  actual  selling  price  minus  a  reasonable  allowance  for  selling 
expenses  and  for  manufacturing  expenses,  if  any,  incurred  in 
the  taxable  year  1918,  and  attributable  to  such  goods."  *^  It 
would  seem,  however,  that  the  ruling  should  be  that  the  loss 
to  be  allowed  is  the  difference  between  the  replacement  value 
of  the  goods  at  the  time  of  the  sale,  if  less  than  cost,  and  the 
value  at  which  they  were  taken  in  the  inventory.  The  ruling 
in  force  appears  to  ignore  the  provision  that  the  allowable  loss 
must  result  from  a  "material  reduction  ...  of  the  value  of  the 
inventory"  and  does  not  make  the  allowable  deduction  in  any 
way  turn  upon  such  a  reduction. 

Under  the  provision  as  interpreted  by  the  Treasury, 
almost  the  only  clear  case  where  inventory  losses  were  allow- 
able is  that  of  liquor  dealers,  whose  stocks  subsequently  became 
unsaleable  for  beverage  purposes  on  account  of  prohibition.** 

The  inventory  loss  provision  is  not  easy  to  apply  satisfac- 
torily, but  it  is  so  just  in  principle  that  its  scope  should  be 

"  Art.  264. 

«•  O.  D.  390,  Cum.  Bui.  No.  2,  p.  156. 


t     ' 


! 


1»J. 


>i 


11: 


1 86 


COLUMBIA  INCOME  TAX  LECTURES 


extended  to  cover  later  years  and  the  ambiguities  as  to  its 
meaning  should  be  removed. 

Goods  Abroad — Foreign  Money 

The  Committee  on  Appeals  and  Review  has  ruled  that: 

Under  the  abnormal  conditions  characterizing  foreign  exchange 
during  the  European  War,  the  taxpayer  may  convert  current  assets 
less  current  liabilities  payable  in  the  foreign  currency  at  the  current 
rate  of  exchange  or  at  any  rate  less  favorable  to  him.  .  .  .  This  ruling 
should  apply  primarily  to  taxpayers  trading  or  manufacturing  in 
foreign  countries  and  should  not  be  held  to  apply  to  isolated  or  collateral 
investments  in  foreign  credits  or  securities.** 

Under  this  ruling  the  net  profits  of  the  operation  of  a  foreign 
branch,  except  so  far  as  actually  remitted  to  the  home  ofhce, 
are  to  be  converted  into  United  States  money  at  the  rate  of 
exchange  prevailing  at  the  end  of  the  taxable  year,  or  at  any 
rate  less  favorable  to  him.  In  the  case  of  the  amount  actually 
remitted,  the  rate  of  exchange  used  in  making  the  payment  is 
to  be  employed.^® 

The  Treasury  has  also  ruled  that  foreign  money  on  hand  in  a 
branch  abroad  at  the  close  of  the  year,  may  be  taken  into 
account  by  treating  it  as  converted  into  United  States  cur- 
rency at  the  current  rate  of  exchange. 

Future  Developments 

Because  of  the  present  slump  in  commodity  values  it  is 
very  clear  that  rigid  rules  laid  down  with  much  logical  justifi- 
cation may  work  gross  injustice  through  imposing  tax  on 
income  which  is  not  real.  This  injustice  should  lead  to  amelio- 
rative provisions  in  the  law  itself,  such  as  the  extension  to 
all  years  of  the  inventory  loss  sections  and  of  the  net  loss 
sections.  But  it  must  also  call  for  careful  further  considera- 
tion by  the  Treasury  of  its  own  rulings.  Business  men  must 
be  ready  to  assist  the  Treasury  in  its  necessary  task  of  placing 
the  treatment  of  inventories  upon  an  open  and  intelligible 

«•  A.  R.  R.  IS.  3-20-682.  Cum.  Bui.  No.  2.  p.  60;    O.  D.  489.  19-20-909.  Cum.  Bui. 
No.  2,  p.  60. 

»»0.  D.  sso,  25-20-1009.  Dige«t  No.  11.  Cf.  pp.  50-52. 


inventories 


187 


basis.  The  Treasury,  however,  must  be  ready  to  give  much 
weight  to  the  counsels  of  experience.  It  has  under  the  law  a 
mandate  to  give  recognition  to  the  "best  accounting  practice" 
in  each  trade  or  industry,  and  should  not  interpret  this  phrase 
as  referring  merely  to  methods  which  have  been  actually 
established,  but  as  covering  the  best  methods  which  can  be 
established,  in  the  light  of  experience,  and  with  a  view  to 
meeting  fairly  the  necessity  of  tax  administration.  Such 
consideration  seems  bound  to  result  in  the  modification  of 
some  of  the  present  requirements.** 

»» Just  such  a  modification  has  recently  been  occurring.     Cf.  T.  D.  3104,  3108  and  31  oq. 


♦ 

I. 


f 


\ 


(   { 


I 


CONSOLIDATED     RETURNS 


189 


CONSOLIDATED  RETURNS 

BY 

Walter  A.  Staub,  C.  P.  A. 

Origin  and  History.  Prior  to  1917  none  of  our  federal  income 
tax  laws  permitted  the  filing  of  consolidated  returns  by 
affiliated  corporations.  Consequently,  if  one  of  two  affiliated 
corporations  showed  a  large  profit,  and  the  other  a  consider- 
able loss,  the  full  tax  had  to  be  paid  on  the  profit  without 
any  offset  being  allowed  for  the  loss  sustained  by  the  un- 
profitable company. 

In  many  cases  taxpayers,  because  of  the  small  rate  of  tax 
imposed,!  simply  accepted  the  condition  as  it  was,  paid  the 
tax  in  the  case  of  the  profitable  company,  and  let  it  go  at  that. 
Others,  however,  of  a  more  thrifty  nature,  in  effect  secured  an 
offset  for  the  loss  by  making  inter-company  charges  or  allow- 
ances, as,  for  example,  management  charges  from  one  com- 
pany to  another,  or  a  rebate  on  the  charges  previously  made 
for  merchandise  supplied  one  company  by  the  other. 

The  aim  of  such  adjustments,  where  it  was  feasible  to  make 
them,  was  to  reduce  or  practically  eliminate  the  loss  of  the 
unprofitable  company,  and  to  reduce  correspondingly  the 
taxable  income  of  the  profitable  company. 

With  the  passage  of  the  excess  profits  tax  law,  however, 
which  imposed  unprecedentedly  heavy  taxes  and  introduced 
an  entirely  new  problem,  viz.,  that  of  determining  invested 
capital  as  an  essential  feature  of  the  administration  of  the  tax, 
the  Treasury  recognized  not  only  the  justice  of  but  also  the 
necessity  for  consolidated  returns  in  the  case  of  corporations 
where  there  was  either: 

I.  Affiliation  or  community  of  financial  interest,  as  in  the 
case  of  corporations  where  one  or  more  companies  were  owned 
by  a  parent  company,  or  where  two  or  more  corporations  were 

»  From  1909  to  191S.  inclusive,  the  rate  was  only  one  per  cent.,  and  for  1916  only  two 
per  cent.,  on  taxable  net  income. 


owned  by  the  same  interest  or  interests  as  individuals  or 
partnership;  or, 

2.  The  business  relations  between  the  companies  were  such 
that  even  though  there  was  not  actual  stock  ownership  in 
common,  or  by  a  parent  company,  it  was  possible  to  manipu- 
late profits  and  losses  as  between  the  companies. 

The  191 7  law  itself  did  not  specifically  provide  for  consoli- 
dated returns.  Acting,  however,  upon  the  advice  of  the 
Advisory  Tax  Board,  which  the  Commissioner  of  Internal 
Revenue  had  called  into  being,  the  regulations  promulgated 
by  the  Treasury  for  the  administration  of  the  191 7  excess 
profits  tax  act  provided  for  the  submission  of  returns  which, 
under  certain  conditions,  were  to  be  consolidated  for  excess 
profits  tax  purposes  but  not  for  purposes  of  the  income  tax. 

The  191 7  regulations  permitting  or  requiring  consolidated 
excess  profits  tax  returns  do  not  specifically  state  what  section 
of  the  law  is  relied  upon  for  such  permission  or  requirement, 
but  it  is  supposed  to  have  been  the  following  part  of  Section 
201  of  the  Act  of  October  3,  191 7: 

For  the  purpose  of  this  title  every  corporation  or  partnership  not 
exempt  under  the  provisions  of  this  section  shall  be  deemed  to  be 
engaged  in  business,  and  all  the  trades  and  businesses  in  which  it  is 
engaged  shall  be  treated  as  a  single  trade  or  business,  and  all  its  income 
from  whatever  source  derived  shall  be  deemed  to  be  received  from 
such  trade  or  business. 

It  would  seem  from  a  reading  of  the  foregoing  section  of  the 
law  that  it  was  scarcely  intended  to  provide  for  consolidated 
excess  profits  tax  returns  of  separate  corporations,  any  more 
than  the  general  provision  in  the  various  income  tax  acts, 
requiring  that  all  income  from  all  sources  be  included  in 
returns,  could  be  construed  as  calling  for  consolidated  income 
tax  returns  from  affiliated  corporations. 

However,  in  view  of  the  defects  of  the  191 7  excess  profits 
tax  act  and  the  possible  harm  which  might  otherwise  have  been 
done  to  business  interests,  the  regulation  was  a  very  necessary 
one.  Yet,  as  is  pointed  out  elsewhere  in  this  paper,  some 
disadvantage  was  suffered  by  corporations  joining  in  a  consoli- 
dated return,  in  that  they  lost  the  benefit  of  another  regulation 


1"=* 


i 


? 


I90      COLUMBIA     INCOME     TAX     LECTURES 

permitting  the  offsetting  of  liability  against  inadmissible 
assets.  This  last  mentioned  regulation  also  granted  a  privilege 
not  provided  in  the  law  itself. 

The  regulation  permitting  consolidated  returns  met  with 
widespread  approval  among  business  and  financial  interests 
and  was  thoroughly  warranted  from  the  standpoint  of  a  fair 
administration  of  the  law.  The  distinction  between  wholly- 
owned  subsidiaries  and  a  parent  corporation,  as  well  as  between 
companies  wholly  owned  by  one  interest  or  set  of  interests,  is 
only  a  technical  one  and  in  fact  is  no  more  real,  or  for  profits 
tax  purposes  justifiable,  than  it  would  be  to  require  separate 
returns  from  the  different  departments  of  one  corporation. 

No  case  has,  to  the  writer's  knowledge,  yet  reached  the 
courts  in  which  taxpayers  have  insisted  upon  filing  separate 
returns  instead  of  a  consolidated  return  for  affiliated  corpora- 
tions, though  it  is  a  question  whether,  if  there  were  an  advan- 
tage in  doing  so,  the  taxpayer  could  not  enforce  the  right  to 
make  separate  returns.  This  is  true,  however,  only  with 
reference  to  the  year  191 7,  as  the  law  now  in  force*  makes 
mandatory  the  filing  of  consolidated  returns  under  which 
corporations  are  affiliated  as  defined  in  the  act. 

What  Corporations  Should  Make  a  Consolidated  Return? 
The  191 8  law  states  that  for  the  purpose  of  making  consolidated 
returns,  two  or  more  domestic  corporations  shall  be  deemed 
to  be  affiliated : 

1.  If  one  corporation  owns  directly  or  controls  through 
closely  affiliated  interests  or  by  a  nominee  or  nominees  sub- 
stantially all  the  stock  of  the  other  or  others,  or 

2.  If  substantially  all  the  stock  of  two  or  more  corporations 
is  owned  or  controlled  by  the  same  interest.' 

Article  633  of  Regulations  45  states  that  "the  words  'sub- 
stantially all  the  stock'  cannot  be  interpreted  as  meaning  any 
particular  percentage,  but  must  be  construed  according  to  the 
facts  of  the  particular  case."    The  article  goes  on  to  state  that : 

The  owning  or  controlling  of  ninety-five  per  cent,  or  more  of  the 
outstanding  voting  capital  stock  (not  including  stock  in  the  treasury) 

'  Section  240  of  Act  of  February  24,  1919  (retroactive  to  January  i,  1918.  and  commonly 
referred  to  as  the  1918  act  or  1918  law). 
•  Section  240  (b). 


CONSOLIDATED     RETURNS 


191 


at  the  beginning  of  and  during  the  taxable  year  will  be  deemed  to 
constitute  an  affiliation  within  the  meaning  of  the  statute.  Consoli- 
dated returns  may,  however,  be  required  even  though  the  stock  owner- 
ship is  less  than  ninety-five  per  cent. 

When  the  stock  ownership  is  less  than  ninety-five  per  cent.,  but  m 
excess  of  fifty  per  cent.,  a  full  disclosure  of  affiliations  should  be  made, 
showing  all  pertinent  facts,  including  the  stock  owned  in  each  subsidiary 
or  affiliated  corporation  and  the  percentage  of  such  stock  owned  to  the 
total  stock  outstanding.  Such  statement  should  preferably  be  made  in 
advance  of  filing  the  return,  with  a  request  for  instructions  as  to  whether 
a  consolidated  return  should  be  made.  In  any  event  such  a  statement 
should  be  filed  as  a  part  of  the  return. 

The  words  "the  same  interests"  shall  be  deemed  to  mean  the  same 
individual  or  partnership  or  the  same  individuals  or  partnerships,  but 
when  the  stock  of  two  or  more  corporations  is  owned  by  two  or  more 
individuals  or  by  two  or  more  partnerships  a  consolidated  return  is  not 
required  unless  the  percentage  of  stock  held  by  each  individual  or  each 
partnership  is  substantially  the  same  in  each  of  the  affiliated  corpora- 
tions. 

In  a  case  in  which  the  construction  of  the  phrase  "substan- 
tially all  the  stock  of  two  or  more  corporations"  was  at  issue, 
the  Treasury  held  as  follows: 

The  application  to  make  a  consolidated  return  was  denied  in  the 
case  of  two  companies  in  one  of  which  24.26  per  cent,  of  the  stock  of 
the  first  company  was  owned  by  individuals  who  held  no  stock  whatever 
in  the  second  company,  and  more  than  6  per  cent,  of  the  stock  of  the 
second  company  was  held  by  individuals  who  held  no  stock  in  the  first 
company.  Such  a  division  of  ownership  cannot  be  considered  either 
under  the  statute  or  the  regulations  as  a  case  in  which  substantially  all 
of  the  stock  of  two  or  more  corporations  is  owned  or  controlled  by  the 
same  interests.* 

The  regulations  issued  for  the  administration  of  the  1917 
excess  profits  tax  law,  in  defining  affiliated  corporations  refer 
to  two  classes  of  affiliations,  one  due  to  stock  ownership  or 
control,  and  the  other  due  to  contractual  or  financial  rela- 
tions.   The  latter  form  of  affiliation  is  stated  to  exist  when  one 

corporation : 

(a)  Buys  from  or  sells  to  another  products  or  services  at 
prices  above  or  below  the  current  market,  thus  effecting  an 
artificial  distribution  of  profits,  or 

(b)  In  any  way  so  arranged  its  financial  relationships  with 

« Income  Tax'Rulinga  16-19-465. 


ft 

I 


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't 


J. 


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<• 


192      COLUMBIA     INCOME     TAX     LECTURES 

another  corporation  as  to  assign  to  it  a  disproportionate  share 
of  net  income  or  invested  capital.* 

The  affiliation  by  reason  of  contractual  relations  is  not 
mentioned  in  the  191 8  act  and  no  reference  is  made  thereto 
in  the  regulations.  It  may,  therefore,  be  assumed  that  from 
1918  on,  corporations  which  have  a  community  of  interests  by 
reason  of  contractual  or  financial  relations,  but  not  by 
reason  of  common  stock  ownership  or  control,  are  not  re- 
quired to  join  in  a  consolidated  return.  As  a  matter  of  fact, 
it  is  difficult  to  see  how  corporations  could  establish  such 
contractual  or  financial  relations  (other  than  stock  ownership) 
as  would,  if  they  file  separate  returns,  result  in  a  lesser  aggre- 
gate tax  than  if  they  filed  a  consolidated  return. 

For  the  purpose  of  determining  whether  or  not  corporations 
are  affiliated  within  the  intent  of  the  present  law,  the  Treasury 
has  issued  an  elaborate  "Affiliated  Corporations  Question- 
naire" (Form  819)  which  must  be  filled  out  by  all  those 
.corporations  of  whose  outstanding  voting  capital  stock  more 
than  fifty  per  cent,  is  owned  or  controlled  by  a  parent  com- 
pany, or  of  which  over  fifty  per  cent,  is  owned  or  controlled 
by  the  same  interests  as  have  ownership  of  one  or  more  other 
companies.  The  questionnaire  calls  for  a  mass  of  data.  Many 
of  the  questions  seem  unnecessary  for  the  determination  of 
whether  or  not  a  consolidated  return  should  be  filed.  Further- 
more, the  questionnaire  would  seem  to  be  entirely  unnecessary 
in  those  cases  where  the  parent  company,  as  is  not  unusual, 
owns  one  hundred  per  cent,  of  the  stock  of  all  its  subsidiaries. 
It  would  be  a  decided  accommodation  to  taxpayers  if  in  such 
cases  as  that  of  the  "Affiliated  Corporations  Questionnaire" 
the  Treasury  would  confine  itself  to  requiring  such  information 
as  is  really  essential  to  the  determination  of  the  question  up 
for  consideration. 

Consolidated  Returns  Forbidden  for  Certain  Classes  of  Cor- 
porations. By  restricting  the  definition  of  affiliated  corpora- 
tions to  domestic  corporations,  the  present  law  in  effect  for- 
bids the  inclusion  of  the  invested  capital  and  operations  of 
a  foreign  corporation  in  a  consolidated  return.     This  is  the 

'  Regulations  41.  Art.  77. 


CONSOLIDATED     RETURNS 


193 


case  whether  the  foreign  corporation  is  registered  to  do  busi- 
ness in  the  United  States  or  not.  If  it  is,  such  foreign  corpora- 
tion must  pay  income  tax  to  the  United  States  on  its  income 
derived  from  sources  within  this  country,  and  its  stock  owned 
by  any  American  corporation,  becomes  an  inadmissible  asset 
to  the  latter.  Dividends  received  from  it  are  not  subject  to 
tax  to  the  recipient.  On  the  other  hand,  if  it  does  not  do 
any  business  whatever  in  the  United  States  it  pays  no  income 
tax  to  this  country,  its  capital  stock  is  an  admissible  asset 
to  an  American  corporation,  and  its  dividends  are  subject 
to  tax  (both  income  and  excess  profits)  against  the  American 
corporation .•  None  of  these  conditions,  however,  change  the 
fact  that  under  the  present  law  the  invested  capital  and  income 
of  a  foreign  corporation  cannot,  under  any  circumstances,  be 
merged  in  a  consolidated  return  with  an  American  corporation.^ 
The  other  class  of  corporations  whose  invested  capital 
and  taxable  income  are  not  permitted  to  be  included  in  a 
consolidated  return,  is  defined  as  follows: 

Any  .  .  .  corporation  organized  after  August  i,  1914,  and  not 
successor  to  a  then  existing  business,  fifty  per  centum  or  more  of  whose 
gross  income  consists  of  gains,  profits,  commissions,  or  other  income, 
derived  from  a  Government  contract  or  contracts  made  between  April 
6,  1917,  and  November  11,  1918,  both  dates  inclusive.* 

•  Cf.  Regulations  45,  Articles  301  and  834  and  letter  of  Commissioner  Roper  to  Corpora- 
tion Trust  Company,  dated  June  9,  1919. 

» Section  240  (c)  of  the  1918  law,  while  excluding  a  foreign  corporation  from  a  consoli- 
dated return,  permits  the  parent  domestic  corporation  to  deduct  from  the  income  and  profits 
taxes  payable  by  it  "the  same  proportion  of  any  income,  war-profits  and  excess-profits  taxes 
paid  (but  not  including  taxes  accrued)  by  such  foreign  corporation  during  the  taxable  year 
to  any  foreign  country  or  to  any  possession  of  the  United  States  upon  income  derived  from 
sources  without  the  United  States,  which  the  amount  of  any  dividends  (not  deductible  under 
Section  234)  received  by  such  domestic  corporation  from  such  foreign  corporation  during 
the  taxable  year  bears  to  the  total  taxable  income  of  such  foreign  corporation  upon  or  with 
respect  to  which  such  taxes  were  paid:  Provided,  That  in  no  such  case  shall  the  amount  of 
the  credit  for  such  taxes  exceed  the  amount  of  such  dividends  (not  deductible  under  Sec- 
tion 234)  received  by  such  domestic  corporation  during  the  taxable  year." 

The  regulations  pertaining  to  the  treatment  of  stock  of  foreign  corporations  in  deter- 
mining invested  capital  under  the  19 17  law  prescribed  a  different  procedure  from  that  in 
force  under  the  191 8  law.    Article  46  of  Regulations  41  reads  as  follows: 

"In  the  case  of  domestic  corporations  or  partnerships  and  of  citizens  or  residents  of  the 
United  States  holding  stock  in  a  foreign  corporation  part  of  whose  net  income  is  subject 
to  the  income  tax,  there  shall  be  included  in  invested  capital  such  proportion  of  the  value 
of  the  stock  in  such  foreign  corporation  as  the  net  income  of  such  foreign  corporation 
from  sources  outside  the  United  States  is  of  its  entire  net  income." 

'Section  240  (a). 


11 


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194      COLUMBIA     INCOME     TAX     LECTURES 

The  law  further  provides  that  the  corporation  so  excluded 
from  the  consolidated  return  "shall  be  separately  assessed 
on  the  basis  of  its  own  invested  capital  and  net  income.** 

Should  Partnerships  and  Owned  Corporations  he  Consolidated? 
This  question  need  not  be  seriously  raised  under  the  law  at 
present  in  force  as  the  1918  act  is  very  explicit  in  limiting 
consolidated  returns  to  affiliated  corporations.    The  question 
has  been  raised,  however,  under  the  1917  excess  profits  tax 
law.     As  has  been  stated  in  an  earlier  paragraph,  the  1917 
act  contained  no  specific  requirement  for  consolidated  tax 
returns.    If  that  paragraph  of  Section  201  of  the  act  of  Octo- 
ber 3,  191 7,  which  reads  that  ".    .    .  every  corporation  or  part- 
nership .     .     .  shall  be  deemed  to  be  engaged  in  business, 
and  all  the  trades  and  businesses  in  which  it  is  engaged  shall 
be  treated  as  a  single  trade  or  business  ..."  is  the  war- 
rant   for    the    Treasury    regulations    requiring    consolidated 
returns  in  certain  cases,  it  would  appear  just  as  permissible 
to  require  a  partnership  and  corporations  wholly  owned  by 
it,  or  substantially  so,  to  make  a  consolidated  return  as  in  the 
case  of  affiliated  corporations.    Articles  77  and  78  of  Regula- 
tions 41,  however,  in  dealing  with  the  subject  of  affiliated 
corporations  and  consolidated  returns  make  mention  only  of 
corporations  and  give  not  the  slightest  intimation   that  a 
partnership  and  corporations  owned  or  controlled  by  it  would 
be  required  to  make  consolidated  returns. 

Advantages  and  Disadvantages  of  Consolidating  Returns. 
The  general  impression  has  been  that  the  permission  to  make 
consolidated  instead  of  separate  returns  for  a  group  of  affiliated 
corporations  must  be  of  great  benefit  to  the  corporations.  In 
sonie  respects  this  is  undoubtedly  true.  If  the  rate  of  earnings 
on  invested  capital  of  the  various  companies  of  a  group  varied 
materially,  or  if  one  or  more  companies  sustained  net  losses 
while  others  of  the  group  earned  profits,  the  making  of  a 
consolidated  return  obviously  is  decidedly  advantageous.  As 
will  be  seen,  however,  from  the  later  discussion  of  Inadmissible 
Assets  and  of  Investments  in  Stocks  of  Subsidiaries,  a  consoli- 
dated return  may  as  to  these  items  result  less  advantageously 
to  the  group  than  if  each  affiliated  corporation  made  a  sep- 


CONSOLIDATED     RETURNS 


195 


arate  return.  Also,  by  making  a  consolidated  return  all  of 
the  specific  $3,000  and  $2,000  exemptions  which  a  number  of 
corporations  would  get  under  separate  returns  are  lost  except- 
ing the  one  $3,000  and  one  $2,000  allowed  for  the  affiliated 
group  as  a  whole. 

It  is  practically  certain  that  in  a  broad  way  corporations 
have  benefited  by  being  able  to  make  consolidated  returns  in 
cases  of  affiliation.  The  fact  that  there  are  some  disadvantages 
suffered  as  offsets  to  the  benefits  enjoyed — which  in  isolated 
cases  may  overbalance  the  benefits — is  pointed  out  at  this 
time  merely  so  that  the  general  thought  may  be  in  mind 
that  there  are  various  "give  and  take"  elements  involved  in 
the  consolidated  returns  provision. 

Determining  Consolidated  Taxable  Income.  The  determina- 
tion of  the  consolidated  taxable  net  income  may  involve  the 
handling  of  a  multitude  of  details  and  requires  care  in  properly 
classifying  the  various  items  of  gross  income  and  deductions. 
It  does  not,  however,  involve  many  questions  of  principle 
other  than  those  which  may  arise  in  preparing  the  return  of  a 
corporation  which  has  no  affiliations  with  any  other  company. 
While,  in  preparing  a  true  consolidated  income  return,  there 
are  various  eliminations  to  be  made  for  inter-company  trans- 
actions, these  do  not  for  the  most  part  affect  the  final  aggre- 
gate net  income  of  the  entire  group  of  affiliated  companies. 

There  is,  however,  one  important  principle  to  be  applied  in 
the  determination  of  consolidated  taxable  income  which  finds 
no  place  in  the  return  of  a  corporation  having  no  affiliations. 
This  is  the  elimination  of  inter-company  profits  forming  a  part 
of  the  value  of  goods  in  the  inventory  of  one  corporation 
which  had  been  purchased  from  an  affiliated  company.  The 
recognition  by  the  Treasury  of  the  propriety  of  eliminating 
inter-company  profits  from  the  inventories  of  affiliated  cor- 
porations is  but  the  application  of  an  accounting  principle 
that  has  been  developed  in  the  course  of  the  past  twenty 
years. 

With  the  rise  and  growth  of  groups  of  corporations  owned 
by  a  single  parent  corporation,  it  was  seen  that,  regardless  of 
the  separate  entity  which  each  subsidiary  corporation  legally 


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196       COLUMBIA     INCOME     TAX     LECTURES 

possessed,  the  practical  fact  was  that  each  subsidiary  was  to 
all  intents  and  purposes  but  a  department  of  one  large  business. 
Profits  are  not  actually  realized  by  the  transfer  or  sale  of 
goods  from  one  department  to  another  of  the  same  business. 
Similarly,  the  apparent  profit  resulting  from  the  sale  of  goods 
from  one  subsidiary  to  another  or  from  a  subsidiary  to  a  parent 
corporation,  or  vice  versa,  is  not  actually  realized  until  the 
goods  are  finally  disposed  of  to  the  public.  Unless  inter-com- 
pany profits  are  eliminated  from  the  consolidated  financial 
statements  of  affiliated  corporations,  it  would  be  easily  possible 
to  inflate  the  profit  showing  by  piling  up  inventories  in  those 
companies  which  conduct  the  more  advanced  steps  of  the 
manufacturing  operations  and  having  in  such  inventories 
considerable  quantities  of  goods  purchased  from  other  com- 
panies of  the  group  at  a  profit  to  the  selling  companies. 

In  determining  taxable  income,  it  is  essential  above  all  else 
that  only  definitely  realized  profits  be  included.  Hence,  the 
exclusion  of  inter-company  profits  which  have  not  yet  been 
realized  because  the  goods  on  which  they  have  accrued  are 
still  on  hand,  even  though  now  owned  by  another  company  of 
the  group,  is  essential  to  the  correct  and  fair  stating  of  con- 
solidated taxable  income. 

It  is  rather  strange,  though  it  may  be  mere  accident,  that 
the  Treasury  regulations  refer  to  the  elimination  of  inter- 
company profits  only  in  those  articles  which  prescribe  the 
method  of  determining  invested  capital  for  purposes  of  con- 
solidated returns.  No  mention  thereof  appears  in  the  articles 
referring  to  the  determination  of  consolidated  taxable  net 
income.  However,  inasmuch  as  this  is  an  instance  of  an  item 
which,  if  applied  in  reduction  of  invested  capital,  is  bound  to 
have  a  corresponding  effect  on  taxable  income — inventory 
valuations  must  of  necessity  be  consistently  applied  in  the 
determination  of  both  taxable  income  and  invested  capital — 
there  can  be  no  question  but  that  the  regulations  intend  that 
consolidated  taxable  net  income  shall  be  reported  net  of  inter- 
company profits  in  inventories. 

Further  questions  remain  to  be  considered  as  to  the  pro- 
cedure to  be  followed  in  cases : 


CONSOLIDATED     RETURNS 


197 


a.  When  the  affiliated  companies  had  not  been  eliminating 
inter-company  profits  in  preparing  tax  returns  and  it  is  desired 
to  change  to  that  basis; 

b.  When  companies  which  were  independent  of  each  other 
became  affiliated  during  the  taxable  year. 

With  reference  to  (a),  it  is  to  be  noted  that  Regulations  45, 
which  were  promulgated  for  the  administration  of  the  191 8 
law,  contain  the  earliest  reference  by  the  Treasury  to  the 
subject  of  eliminating  inter-company  profits  from  inventories 
entering  into  a  consolidated  return.  Article  864  reads  in  part 
as  follows : 

The  invested  capital  of  affiliated  corporations  ...  for  the  taxa- 
ble year  is  the  invested  capital  of  the  entire  group  treated  as  one  unit 
operated  under  a  common  control.  As  a  first  step  in  the  computation  a 
consolidated  balance  sheet  should  be  prepared  in  accordance  with 
standard  accounting  practices,  which  will  reflect  the  actual  assets  and 
liabilities  of  the  affiliated  group.  In  preparing  such  a  balance  sheet  all 
inter-company  items,  such  as  inter-company  notes  and  accounts  receiv- 
able and  payable,  should  be  eliminated  from  the  assets  and  the  liabili- 
ties, respectively,  and  proper  adjustments  should  be  made  in  respect  of 
inter-company  profits  or  losses  reflected  in  inventories  which  at  the  beginning 
or  end  of  the  taxable  year  contain  merchandise  exchanged  between  the 
corporations  included  in  the  affiliated  group  at  prices  above  or  pelow  cost  to 
the  producing  or  original  owner  corporation. 

While  the  foregoing  clause  appearing  in  italics  refers  pri- 
marily to  the  stating  and  adjustment  of  the  consolidated 
balance  sheet  for  invested  capital  purposes,  it  is  obvious  that  a 
corresponding  adjustment  is  required  in  stating  the  consoli- 
dated taxable  income.  The  same  thought  underlies  the  stating 
of  the  consolidated  taxable  income  as  the  article  just  quoted 
applies  to  the  determination  of  the  consolidated  invested 
capital,  namely,  that  the  true  income  of  a  group  of  affiliated 
corporations  is  obtained  only  when  the  entire  group  is  "treated 
as  one  unit  operated  under  a  common  control."  Hence  both 
the  19 1 8  law  and  the  regulation  just  quoted  make  manda- 
tory, and  not  merely  permissible,  the  elimination  of  inter- 
company profits  included  in  the  book  profits  of  any  affiliated 
corporations  making  a  consolidated  return. 

The  question  remains  as  to  how  affiliated  corporations  which 
had  not  been  eliminating  inter-company  profits  in  stating  their 


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198      COLUMBIA     INCOME     TAX     LECTURES 

consolidated  income  shall  make  the  change  to  the  basis  called 
for  by  Article  864.  Prior  to  1918  affiliated  corporations  were 
not  permitted  to  make  consolidated  income  tax  returns. 
While  consolidated  excess  profits  tax  returns  were  permitted 
for  1917,  this  was  by  administrative  action  rather  than  by 
direction  of  the  law  itself.  Further,  the  income  embraced  in  a 
consolidated  excess  profits  return  for  1917  was  required  by  law 
to  be  the  same  as  that  reported  in  the  separate  income  tax 
returns  of  the  several  affiliated  corporations, »  and  the  regula- 
tions promulgated  for  the  administration  of  the  1917  excess 
profits  tax  law  made  no  provision  for  any  such  modification 
of  the  aggregate  of  the  income  reported  for  the  separate 
companies  as  the  elimination  of  inter-company  inventory 
profits. 

It  follows,  that  prior  to  1918  there  was  no  provision  in  either 
the  law  or  the  regulations  for  excluding  or  eliminating  inter- 
company profits  from  the  income  or  excess  profits  tax  returns 
of  affiliated  corporations.  It  would,  therefore,  be  logical  to 
initiate  the  practice  of  eliminating  such  inter-company  profits 
for  the  first  time  in  preparing  the  consolidated  return  of  a 
group  of  affiliated  corporations  for  the  year  1918.  Should  the 
change  not  be  made  until  some  time  after  191 8  it  would  appear 
that  the  proper  procedure  would  be  to  file  an  amended  con- 
solidated return  for  1918  and  the  subsequent  years,  giving 
effect  to  the  elimination  of  inter-company  profits  as  at  the  close 
of  the  period  (fiscal  or  calendar  year)  for  which  the  191 8  return 
is  made  and  as  at  the  beginning  and  end  of  each  of  the  succeed- 
ing years  for  which  amended  returns  are  being  filed. 

It  may  be  further  pointed  out  that  prior  to  1917  the  Treasury 
required  that  inventories  should  be  valued  at  cost  regardless 
of  whether  or  not  market  values  were  less  than  such  cost.  In 
December,  1917,  i.e.,  after  the  enactment  of  the  1917  excess 
profits  tax,^o  the  Treasury  issued  a  decision  ^^  recognizing  the 
propriety  of  valuing  inventories  at  either  cost  or  market, 
whichever  is  the  lower.     This  practice  has  continued  to  be 

•  1917  law,  Sec.  206  (c). 
M  Act  of  October  3,  191 7. 
»» T.  D.  2609. 


CONSOLIDATED     RETURNS 


199 


recognized  in  principle  since  that  time.    Article  1582  of  Regu- 
lations 45  provided  inter  alia  that: 

A  taxpayer  may,  regardless  of  his  past  practice,  adopt  the  basis  of 
cost  or  market,  whichever  is  lower,  for  his  191 8  inventory,  provided  a 
disclosure  of  the  fact  and  that  it  represents  a  change  is  made  in  the 
return.  Thereafter  changes  can  be  made  only  after  permission  is  se- 
cured from  the  Commissioner. 

Inasmuch  as  the  elimination  of  inter-company  profits  from 
the  inventories  of  a  group  of  affiliated  corporations  is  in  effect 
reducing  the  inventories  "of  the  entire  group  treated  as  one 
unit  operated  under  a  common  control"  to  cost.  Article  1582 
would  be  an  additional  warrant  for  making  the  change  in  the 
1918  consolidated  return  to  the  basis  of  valuing  inventories 
exclusive  of  inter-company  profits. 

Regarding  case  (6),^^  nothing  has  come  to  the  attention  of 
the  writer  in  either  the  formal  regulations  or  the  less  formal 
rulings  of  the  Treasury  bearing  on  the  question.  Inasmuch  as 
when  corporations  become  affiliated  during  a  taxable  year  they 
acquire  a  new  relationship  to  each  other,  it  would  appear  that 
the  time  for  making  the  change  to  the  basis  of  eliminating 
inter-company  profits  in  inventories  of  the  corporations  now 
affiliated  is  the  close  of  the  period  for  which  the  initial  con- 
solidated return  is  made. 

At  first  glance  it  might  seem  objectionable  to  eliminate 
such  inter-company  inventory  profits  at  the  close  of  the  period 
without  making  corresponding  adjustment  at  the  beginning 
of  the  period.  As  against  this  objection,  however,  it  is  to  be 
pointed  out  that  the  individual  companies,  prior  to  their  con- 
solidation, had  already  reported  and  paid  taxes  on  such  inter- 
company profits  included  in  the  inventories  at  the  beginning 
of  the  period.^'  Since  the  change  must  be  made  some  time, 
there  is  no  more  logical  period  than,  or  none  in  fact  as  logical 
as,  the  taxable  year  in  which  the  affiliation  among  the  corpora- 
tions takes  place. 

Also,  as  will  be  seen  from  the  later  discussion  of  consolidated 
invested    capital,    affiiliated    corporations    sometimes    suffer 

*•  How  or  when  inter-company  profits  are  to  be  eliminated  when  companies  which  were 
independent  of  each  other  became  affiliated  during  the  taxable  year.    Cf.  supra,  p.  197. 

'•  This  follows  the  reasoning  expressed  in  the  Treasury's  latest  ruling  concerning  the 
determination  of  the  taxable  income  of  instalment  businesses.   T.  D.  3082,  October  20, 1920. 


,  i 


I. 


200      COLUMBIA     INCOME     TAX     LECTURES 

instead  of  benefit  by  the  making  of  a  consolidated  return. 
Consequently,  if  they  apparently  benefit  by  eliminating 
inter-company  inventory  profits  at  the  end  of  the  period  for 
which  the  initial  consolidated  return  is  made  without  making 
a  corresponding  elimination  at  the  beginning  of  such  period, 
one  is  in  a  sense  a  compensation  for  the  other.  This  is  but  one 
instance  of  the  "give  and  take"  element  which  seems  to  be 
almost  inevitable  in  the  application  of  a  general  tax  law  to 
individual  cases  of  infinite  variety  as  regards  the  special 
circumstances  in  each  particular  case. 

Determining  Consolidated  Invested  Capital.  In  a  broad  way, 
the  consolidated  invested  capital  is  but  the  aggregate  of  the 
invested  capital  resulting  from  the  determination  thereof 
for  each  one  of  the  several  affiliated  corporations.  The 
eliminations  of  inter-company  items  in  preparing  the  invested 
capital  schedule  and  the  supporting  schedules,  such  as  the 
balance  sheets  at  beginning  and  end  of  the  period,  are  for 
the  most  part  of  a  kind  which  do  not  affect  the  aggregate 
invested  capital.  There  are,  however,  a  number  of  most 
important  exceptions,  that  is,  cases  in  which  by  making  a 
consolidated  return,  a  different  result  will  at  times  be  reached 
for  certain  elements  of  the  invested  capital  from  what  would  be 
shown  by  merely  aggregating  the  items  as  they  would  appear 
if  a  separate  return  were  made  for  each  of  the  several  affiliated 
corporations. 

Inter-company  profits  in  inventories  come  into  the  class  of 
exceptions  referred  to  above.  That  subject  has  already  been 
dealt  with  at  considerable  length  in  connection  with  the  de- 
termination of  consolidated  taxable  income  and  need  not  be 
considered  again  in  connection  with  the  consolidated  invested 
capital  as  its  bearing  thereon  is  obvious.  Other  subjects 
which  will  need  to  be  considered  in  some  detail  in  connection 
with  consolidated  returns  are  those  of  inadmissible  assets, 
intangible  assets  and  especially  the  thorny  question  of  the 
treatment  of  investments  in  subsidiary  corporations  in  those 
cases  where  such  stocks  have  been  acquired  for  either  more 
or  less  than  the  then  book  value  thereof  in  the  accounts  of  the 
subsidiaries. 


CONSOLIDATED     RETURNS 


201 


Inadmissible  Assets,  The  treatment  of  the  inadmissible 
assets  is  perhaps  the  simplest  of  the  several  questions  just 
mentioned.  Obviously,  if  the  point  of  departure  for  the 
determination  of  the  consolidated  invested  capital  is  to  be 
a  consolidated  balance  sheet  prepared  on  sound  and  accepted 
accounting  principles,^*  the  stocks  of  subsidiary  corporations 
owned  by  the  parent  corporation  will  be  entirely  eliminated 
from  the  balance  sheet,  and  only  stocks  of  companies  other 
than  those  forming  part  of  the  affiliated  group  would  be  taken 
into  account  in  calculating  the  deduction  to  be  made  from  the 
consolidated  invested  capital  for  inadmissible  assets. 

Were  inadmissible  assets  required  to  be  deducted,  dollar 
for  dollar,  from  the  capital  stock  and  surplus  of  corporations, 
the  result  would  be  just  the  same,  whether  the  deduction  for 
inadmissible  assets  were  calculated  separately  for  each  com- 
pany in  the  group  and  then  aggregated,  or  whether  the  deduc- 
tion were  determined  by  making  but  one  calculation  for  the 
inadmissible  assets  after  having  prepared  the  consolidated 
balance  sheet.    The  191 8  law,^^  however,  in  effect  requires  that 
a   corporation    having   liabilities   deduct    from    its   invested 
capital  only  such  a  proportion  of  the  inadmissible  assets  as  the 
invested  capital  before  such  deduction  is  of  the  gross  assets. 
Or,  expressed  in  another  way,  the  deduction  for  inadmissible 
assets  is  the  amount  of  such  assets  less  a  proportionate  part 
of   the   corporation's   liabilities.     Therefore,    it   may   make 
a  great  difference  whether  the  deduction  is  calculated  sepa- 
rately for  each  corporation  and  then  aggregated,  or  whether 
the  deduction   is   calculated   en    bloc.     The    difference   will 
perhaps  be  more  readily  understood  from  the  following  illus- 
tration : 

»«  For  two  excellent  paper,  on  the  subject  of  consolidated  accounts,  the  reader  is  referred 
to  -The  Accounting  of  Industrial  Enterprises."  by  William  M.  Lybrand.  C  P.  A.  Uourr,^ 
of  Accountancy,  vol.  7.  PP-  32-40.  iii-"i.  224-236)  and  -Consolidated  AccounU  by 
George  R.  Webtter.  C.  P.  A.  {ibid.,  vol.  28.  pp.  2S»-27a). 

"  Section  326  (c). 


■^    I 


202       COLUMBIA     INCOME     TAX     LECTURES 

Summary  of  Balance  Sheets  of  Two  Affiliated  Cor- 
porations Having  the  Relationship  of  Parent 
AND  Subsidiary  Corporations 


Assets 
Inadmissible  assets: 
Stock  of  affiiliated  company 
Other  stocks  and  tax-ex- 
empt bonds 


Admissible  assets; 

Total  assets 
Liabilities 
Total  indebtedness 

Net  assets 
Capital 
Capital  Stock 
Surplus 


Corporation 
A 

yi,ooo,ooo^« 

500,000 

^1,500,000 
3,500,000 

^5,000,000 

^2,500,000 


Corporation    Consolidated 
B 


^500,000 

none 
^1,000,000        4,500,000 


^1,000,000     ^5,000,000 
none  ^2,500,000 


^2,500,000       ^1,000,000     ^2.500,000 


^2,000,000 
500,000 


^1,000,000"     ^2,000,000 
none  500,000 


Total  capital 


^2,500.000       ^i. 000.000     ^2.500.000 


Were  the  invested  capital  of  corporations  A  and  -B  to  be 
determined  separately,  the  calculation  would  be  made  as 
follows: 

Corporation  A: 
Capital  stock  and  surplus,  as  above 
Deduct  for  inadmissibles: 
1,500.000  . 

5,000,000  ""^  ^o^egomg  ^2.500.000 

Invested  capital  of  A 
Corporation  B: 

Capital  stock  and  surplus,  as  above  (no  deduction  for 
inadmissibles  necessary) 


^2,500,000 

750,000 
^1,750,000 

^1,000,000 


Aggregate  of  invested  capital  determined  separ- 
ately for  each  corporation  ^2,750,000 

"  Offset  and  excluded  in  stating  the  consolidated  balance  sheet  in  the  last  column. 
For  the  sake  of  simplicity,  it  has  been  assumed  that  the  stock  of  corporation  B  was  acquired 
by  corporation  ^  at  par  and  that  corporation  B  has  no  undistributed  surplus. 


consolidated    returns 


203 


Determining  the  invested  capital  of  the  two  corporations 
on  the  basis  of  the  foregoing  consolidated  figures,  the  calcula- 
tion would  be  as  follows: 

Capital  stock  of  parent  company  (all  of  subsidiary's 
stock  owned  by  parent  corporation,^^  and  combined 
surplus  of  parent  and  subsidiary),  assuming  that 
none  of  subsidiary's  surplus  was  accumulated  prior 
to  the  acquisition  of  its  stock  by  the  parent  corpora- 
tion," as  above 

Deduct  for  inadmissibles; 

S«''°°°of«2,50O,000 


5,000,000 

Consolidated  invested  capital 


^2,500,000 

250,000 
^2,250,000 


It  will  be  seen  that  the  calculation  of  the  invested  capital 
on  a  consolidated  basis  is  much  less  than  if  determined  as  the 
aggregate  of  the  invested  capital  calculated  for  each  company 
separately.  In  the  illustration  before  us,  the  greater  part  of 
the  difference  of  $500,000  between  the  respective  amounts  of 
invested  capital  determined  on  the  two  bases  is  due  to  the  ex- 
clusion of  the  subsidiary  corporation's  capital  stock  from  the 
calculation  on  a  consolidated  basis. 

It  is  quite  clear  that  (aside  from  the  treatment  of  inadmissi- 
ble assets  representing  securities  other  than  those  of  affiliated 
corporations),  if  the  parent  company  has  any  liabilities,  the 
consolidated  invested  capital  is  bound  to  be  less  under  either 
the  1918  act  or  the  1917  regulations  ^»  than  the  aggregate  of  the 

"  Article  864  of  Regulations  45  provides  that  the  consolidated  invested  capital  shall 
include  -the  capital  stock,  if  any.  of  subsidiary  companies  not  owned  by  the  parent  or 
principal  company,  together  with  the  surplus,  if  any.  belonging  to  such  minority  interest. 
"Article  864.  above  referred  to.  and  articles  867  and  868  would,  in  effect,  seem  to 
exclude  from  consolidated  invested  capital  any  surplus  of  subsidiary  compames.  accumu- 
lated prior  to  acquisition  of  the  subsidiaries'  stocks,  which  is  not  represented  in  the  pnce 
paid  by  the  parent  company  in  acquisition  of  such  stocks.  This  subject  is  discussed  on 
pages  209-216  under  the  heading.  Investments  in  Stocks  of  Subsidiaries. 

»  WhUe  the  1917  excess  profiU  tax  law  apparently  required  that  the  inadnuisible  asKts 
be  eliminated  in  fuU  from  invested  capital,  the  Treasury  permitted  the  corporation  to 
offset  its  liabilities  against  its  inadmissible  assets  and  required  it  to  reduce  its  invested 
capital  by  only  the  excess,  if  any.  of  inadmissible  assets  over  liabUities  {cf.  Schedule  C. 
Item  8.  in  Form  1003).  This  was  presumably  in  pursuance  of  the  theory  that,  had  the 
corporation  not  acquired  the  inadmissible  assets,  it  would  not  have  had  a  corresponding 
amount  of  liabilities,  and  that  therefore  its  invested  capital  would  have  been  just  as  large 
did  it  not  own  the  inadmissibles.  The  criticism  might  weU  be  made,  however,  that  the 
income  from  the  inadmissible  assets,  whether  dividends  or  stocks  or  interest  on  tax  exempt 
bonds,  was  not  subject  to  excess  profits  tax.  whereas  the  interest  paid  on  liabUiUes  was 
an  allowable  deduction  from  income  unless  the  indebtedness  had  been  specifically  incurred 


I 


J-  i 


I 
1=  ; 


II 


h\\. 


204       COLUMBIA     INCOME     TAX     LECTURES 

invested  capital  determined  separately  for  each  of  the  affili- 
ated corporations.  This  is  the  case  because  in  determining  the 
invested  capital  of  each  corporation  separately  the  parent  cor- 
poration would  not  deduct  from  its  invested  capital  the  full 
amount  of  the  stocks  of  subsidiaries  owned  by  it  but  only  the 
portion  required  by  the  1917  regulations  or  the  1918  act.  In 
determining  consolidated  invested  capital,  however,  the  invest- 
ment of  the  parent  company  in  stocks  of  subsidiaries  is  in  effect 
eliminated  to  the  full  extent  to  which  such  investment  is  repre- 
sented by  capital  and  surplus  appearing  on  the  books  of  the  sub- 
sidiaries at  the  time  of  acquisition  by  the  parent  corporation. 

The  question  may  naturally  be  raised  whether  there  is  any 
justification  for  depriving  the  parent  corporation  (in  the  illus- 
tration it  is  corporation  A)  20  of  any  part  of  the  invested  capital 
which  would  be  shown  if  the  two  companies  were  to  make 
separate  returns.  A  corporation  which  owns  a  considerable 
part  of  the  stock  of  another  corporation,  but  not  a  sufficient 
amount  ("substantially  all")  to  bring  it  within  the  requirement 
for  a  consolidated  return,  pays  no  income  or  profits  tax  on  the 
dividends  received  on  such  stock  and  yet  indirectly  is  permitted 
(if  the  owning  corporation  has  liabilities)  to  include  a  part  of 
the  investment  in  its  invested  capital.  The  parent  corporation 
owning  100  per  cent.,  or  approximately  so,  of  the  stock  of  sub- 
sidiaries is  in  an  analogous  position  but  is  deprived  of  any 
of  the  benefit — so  far  as  its  investment  in  subsidiaries  is  con- 
cerned—resulting from  the  favorable  manner  in  which  section 
326  (c)  permits  the  deduction  for  inadmissible  assets  to  be  made. 

The  only  answer  which  presumably  could  be  made  is, 
that  when  a  corporation  has  wholly,  or  almost  wholly, 
acquired  ownership  of  one  or  more  others,  they  have  to  all 
intents  become  merely  departments  of  one  business  and  should 

for  the  purchase  of  tax  exempt  securities.  Probably  in  most  cases  the  indebtedness  in  effect 
existing  because  of  the  ownership  of  inadmissible  assets  had  been  incurred  indirectly  and 
not  in  such  a  way  as  to  make  the  interest  thereon  an  unallowable  deduction  under  Section 
la  (a)  of  the  Act  of  September  8,  1916,  as  amended  October  3.  1917.  The  effect  of  the 
regulations  under  the  1917  law  was  to  accentuate  still  further  the  difference  under  the  1918 
law  between  the  invested  capital  of  affiliated  corporations  as  determined  separately  and 
then  aggregated  and  as  calculated  on  a  consolidated  basis. 

*  In  the  final  analysis  the  increased  tax  following  any  decrease  in  invested  capital  result- 
ing from  making  returns  on  a  consolidated  basis  falls  on  the  stockholders  of  the  parent 
corporation. 


CONSOLIDATED     RETURNS 


205 


be  treated  as  such  rather  than  as  separate  units.  There  is 
now  in  reality  but  one  investment,  that  of  the  parent  company 
stockholders,  the  capital  investment  of  the  subsidiary  being 
such  in  name  only  and  all  its  stockholders  (with  the  possible 
exception  of  an  insignificant  minority  interest)  having  been 
replaced  by  the  parent  corporation's  investment.  On  the 
other  hand,  as  long  as  the  companies  are  not  sufficiently 
united  in  their  financial  relations  to  bring  them  within  the 
requirement  for  a  considerable  return,  there  is  presumably 
sufficient  independent  financial  interest  or  investment  in  each 
corporation  to  warrant  the  making  of  separate  returns. 

Admittedly,  this  is  not  a  very  satisfactory  answer.  Evi- 
dently, if  all  the  possibilities  of  the  requirement  for  consoli- 
dated returns  and  of  the  provision  prescribing  the  manner  in 
which  the  deduction  for  inadmissibles  is  to  be  made  were 
recognized  before  the  enactment  of  the  1918  law— which, 
however,  does  not  seem  likely— the  only  conclusion  possible 
would  seem  to  be  that  it  was  felt  that  the  line  must  be  drawn 
somewhere  with  the  effect  already  indicated. 

Aside  from  the  loss  of  invested  capital  suffered  by  excluding 
the  investment  in  stocks  of  subsidiaries  from  consideration, 
there  may  be  a  further  disadvantage  sustained  when  deter- 
mining the  deduction  for  other  inadmissibles  in  a  consolidated 
return.  For  instance,  if  in  the  illustration  shown  on  page  202 
the  stock  of  corporation  B  owned  by  corporation  A  were  first 
eliminated,  the  comparison  of  the  invested  capital  determined 
separately  with  that  determined  on  a  consolidated  basis  would 
be  as  follows : 

Corporation  A 
Capital  stock  and  surplus 

Less,  Capital  stock  of  company  B 


^2,500,000 
1.000,000 

^1,500,000 


Deduct  for  inadmissibles; 
500,000 

of  ^1,500,000 

4,000,000 

Invested  capital  of  A 
Corporation  B  •     j    •    • 

Capital  stock  and  surplus  (no  deduction  for  inadmissi- 
bles necessary) . 

Aggregate  of  invested  capital  determined  separ- 
ately for  each  corporation 


187,500 
^1,312,500 


1,000,000 


^2,312.500 


I    ■ 


li!: 


206      COLUMBIA     INCOME     TAX     LECTURES 

The  invested  capital  determined  on  a  consolidated  basis, 
the  calculation  of  which  is  shown  on  page  203,  is  $2,250,000, 
or  $62,500  less  than  shown  above.  The  latter  amount  repre- 
sents the  difference  between : 

1.  One-eighth  of  Company  ^4'^  liabilities  of  $2,500,000 
which,  under  the  separate  calculation  of  A's  invested  capital, 
as  shown  above,  is  in  effect  allowed  as  invested  capital  in 
place  of  the  $500,000  of  inadmissibles  other  than  B*s  stock 
owned,  and 

2.  One-tenth  of  the  liabilities  of  A  and  B  (still  aggregating 
$2,500,000  as  B  had  no  liabilities),  which  is  in  effect  allowed 
as  invested  capital  in  place  of  the  $500,000  of  admissibles  in 
the  consolidated  calculation. 

The  elimination  of  subsidiary  stocks  cannot  under  any 
circumstances  result  in  benefiting  the  affiliated  corporations 
when  determining  the  invested  capital  on  a  consolidated  basis. 
The  calculation  of  the  deduction  for  inadmissibles  other  than 
subsidiary  stocks,  however,  will  sometimes  result  more  favor- 
ably for  the  taxpayer  when  the  invested  capital  is  calculated 
on  a  consolidated  basis  than  when  calculated  separately  for 
each  affiliated  company.  This  may  be  seen  from  the  following 
illustration  which  is  the  same  as  that  on  page  202,  excepting 
that  the  indebtedness  is  shown  as  being  that  of  company  B 
instead  of  i4,  and  the  former's  admissible  assets  have  been 
increased  and  the  latter 's  decreased  correspondingly.  The 
capital  stock  and  surplus  of  each  company  are  the  same  in 
both  illustrations. 

Corporation    Corporation    Consolidated 
Assets  A  B 

Inadmissible  assets; 

Stock  of  affiliated  company      $  i  ,000,000 

Other  inadmissibles  500,000  ^500,000 


Admissible  assets; 

Total  assets 
Liabilities 
Total  indebtedness 

Net  assets 


^1,500,000        none 
1,000,000     ^3,500,000     ^4,500,000 


^2,500,000      ^3,500,000      ^5,000,000 


none 


2,500,000        2,500,000 


CONSOLIDATED     RETURNS 


Capital 
Capital  stock 
Surplus 

Total  capital 


?2,ooo,ooo     Ji, 000,000 
500,000        none 


207 

^2,000,000 
500,000 


^2,soo,ooo     ^1.000,000     ^2,500,000 


^2, 500,000 


The  invested   capital   if  determined   separately   for  each 
company  would  be  as  follows : 

Corporation  A 
Capital  stock  and  surplus 
Deduction  for  inadmissibles  (in  this  case,  because  of 
A  having  no  liabilities,  it  would  be  the  same 
whether  the  subsidiary  stock  is  first  eliminated  or 
whether  the  deduction  is  calculated  in  accordance 
with  section  326  (c)  for  the  entire  inadmissibles) 
1,500,000 

of  ?2,500,000 


2,500,000 

Invested  capital  of  A 
Corporation  B 
Capital  stock  and  surplus  (no  deduction  for  inadmissi- 
bles necessary) 

Aggregate  of  invested  capital  determined  separately 
for  each  corporation 


1,500,000 
y  1, 000,000 


1,000,000 


^2,000,000 


S2, 500,000     ^1,000,000     ^2,500,000 


The  invested  capital  calculated  on  the  consolidated  basis 
would  be  the  same  as  in  the  first  illustration  (the  consolidated 
assets  and  liabilities  being  the  same  in  both  illustrations)  m., 
$2,250,000.  This  amount  is  $250,000  more  than  the  aggregate 
of  the  invested  capital  determined  separately  for  each  cor- 
poration. This  different  result  is  due  to  the  fact  that  in  the 
second  illustration  A  has  no  liabilities  from  which  a  benefit  is 
to  be  derived  in  calculating  the  deduction  for  inadmissibles, 
whereas  in  making  the  calculation  on  a  consolidated  basis  the 
advantage  is  had  of  the  liabilities  of  B  even  though  that 
company  had  no  inadmissibles. 

Whether  or  not  a  group  of  affiliated  corporations  will  profit, 
or  lose,  as  to  its  deduction  for  inadmissibles  other  than  stocks 
of  subsidiaries  by  making  a  consolidated  return,  will  therefore 
depend  on  the  circumstances  in  each  particular  case. 

Intangible  Property,  In  applying  the  limitation  imposed  by 
section  326  (a-4  and  5)  on  the  amount  of  intangible  property 


i' 


208       COLUMBIA     INCOME     TAX     LECTURES 

which  may  be  included  in  invested  capital,  Article  865  of 
Regulations  45  requires  that,  in  the  case  of  corporations  whose 
afifiliation  is  in  the  nature  of  parent  and  subsidiary  companies, 
the  limitation  shall  be  applied  on  the  basis  of  the  capital  stock 
of  the  parent  corporation  and  the  stock  of  the  subsidiaries 
which  may  be  held  by  others.^*  In  the  case  of  corporations 
affiliated  by  reason  of  ownership  by  the  same  interests,  such 
interests,  however,  not  being  themselves  a  corporation,  the 
article  prescribes  that  the  limitation  is  to  be  applied  separately 
to  each  corporation. 

The  question  suggests  itself  as  to  why  this  distinction  is  to  be 
observed  in  applying  the  limitation  on  intangible  property, 
whereas  a  similar  distinction  is  not  prescribed  in  making  the 
deduction  for  inadmissible  assets.  The  limitation  on  the  in- 
clusion of  intangible  property  in  invested  capital  and  the 
requirement  that  a  deduction  be  made  for  inadmissible  assets 
both  appear  in  the  same  section  (326)  of  the  191 8  law.  Hence, 
it  would  seem  only  logical  that,  if  a  distinction  is  to  be  made 
between  the  two  kinds  of  affiliation  in  applying  the  intangible 
property  limitation,  the  same  distinction  should  be  observed 
in  making  the  deduction  for  inadmissibles.  In  the  Treasury 
regulations,  however.  Article  865,  in  dealing  with  the  subject 
of  intangibles,  calls  for  the  distinction  referred  to  in  the  pre- 
ceding paragraph,  whereas.  Article  866,  in  dealing  with  the 
subject  of  inadmissibles,  requires  the  deduction  to  "be  made 
on  the  basis  of  the  consolidated  balance  sheet."  Article  866 
gives  no  intimation  of  any  different  procedure  for  the  two 
different  classes  of  affiliation. 

Under  the  caption  of  Inadmissible  Assets  it  was  pointed  out 
that  the  calculation  on  a  consolidated  basis  of  the  deduction 
for  inadmissibles  may  result  in  a  smaller  invested  capital  than 
if  the  deduction  were  calculated  separately  for  each  of  the 
affiliated  corporations  and  then  aggregated.    In  the  case  of  the 

"  The  regulations  relating  to  the  procedure  under  the  191 7  law  read  in  part  as  follows: 
"Assets  of  affiliated  or  subsidiary  corporations  which  have  to  be  adjusted  to  meet  the 
statutory  limitations  prescribed  by  section  207  shall  be  valued  as  of  conditions  existing  at 
the  dates  when  such  assets  were  acquired  by  the  respective  affiliated  or  subsidiary  corpora- 
tions and  not  as  of  the  date  when  the  stock  in  such  affiliated  or  subsidiary  corporations  was 
acquired  by  the  parent  or  controlling  corporation." 


CONSOLIDATED     RETURNS 


209 


limitation  on  intangibles  it  would  appear  that-^xceptmg 
in  the  rather  infrequent  event  of  the  parent  company  stock 
being  less  than  that  of  the  subsidiaries-the  application  o  the 
limitation  en  bloc  cannot  result  in  less,  and  may  result  m 
more,  invested  capital  for  the  group  than  if  the  limitation  were 
applied  separately  for  each  affiiliated  corporation.  This  is  due 
to  the  fact  that  some  of  the  companies  may  have  no  intangibles 
among  their  assets,  or  less  than  the  maximum  amount  per- 
mitted to  be  included  in  invested  capital.  By  applying  the 
limitation  en  bloc  the  group  obtains  the  benefit  of  the  capital 
stock  of  these  companies  in  the  calculation,  which  would  not 
be  the  case  if  the  calculation  were  to  be  made  separately  for 

each  company  in  the  group.  ,       ,     u 

Investments  in  Stocks  of  Subsidiaries.  It  has  already  been 
intimated  that  one  of  the  really  difficult  questions  which  must 
be  dealt  with  in  determining  consolidated  investment  capital 
arises  when  stock  of  a  subsidiary  has  been  acquired  by  the 
parent  company  for  either  more  or  less  than  the  book  value  of 
the  subsidiary  stock  at  the  time  of  acquisition.  The  Treasury 
regulations  bearing  on  the  subject  are  brief  and  read  as  follows: 

Affiliated  corporations;  stock  of  subsidiary  acquired  for  cash.  When 
all  of  sul^^tant  ally  all  o  the  stock  of  a  subsidiary  corporation  was  ac- 
Mt^cXthe  cash  so  paid  shall  be  the  basis  to  be  used  in  deter- 
mining the  value  of  the  property  acquired. 

A  fHliated  corporations:  stock  of  subsidiary  acquired  for  stock,  wnere 
stocifoU  subs  dia^  company  w^  acquired  with  the  stock  of  the  paren 
comorny  the  amount  to  be  included  in  the  consolidated  invested  capital 
inTsi^ct  of  the  company  acquired  shall  be  computed  in  the  same 
manne^as  Tf  the  net  tangible  assets  and  the  intangible  assets  had  been 
^CQuk^  fnste^  of  the  stock.  If  in  accordance  with  such  acquisition  a 
pXn  surplus  is  claimed,  such  claim  shall  be  subject  to  the  provisions 
of  Article  837." 

It  is  relatively  seldom  that  the  stock  of  a  subsidiary  is 
acquired  for  exactly  its  book  value  at  the  time  of  acquisition. 
Taking  up  first  those  cases  in  which  the  parent  company  has 
paid  a  price  greater  than  book  value  of  the  stock  acquired, 
it  would  certainly  seem  that  equity  would  require,  that  there 
is  nothing  in  the  law  to  forbid,  and  that  the  regulations  above 

"  Art.  867. 
«  Art,  868. 


210      COLUMBIA     INCOME     TAX     LECTURES 

quoted  permit  the  inclusion  in  the  consolidated  invested 
capital  of  the  entire  amount  actually  invested  by  the  parent 
company  in  the  stock  of  the  subsidiary. 

The  theory  of  the  excess  profits  tax  is  that,  when  the  earn- 
ings of  a  corporation  are  greater  than  a  certain  percentage  of 
the  capital  invested  in  the  business  by  its  owners,  a  part  of 
such  excess  earnings  shall  be  paid  over  to  the  federal  govern- 
ment. Now  there  is  no  question  that  when  a  parent  company 
has  paid  an  amount  for  the  stock  of  a  subsidiary  in  excess  of  the 
book  value  shown  therefor  at  the  time  of  acquisition  there 
has  been  an  actual  investment  of  such  excess  payment.  It 
may  be  true  that  the  excess  has  not  actually  been  paid  into 
the  treasury  of  the  subsidiary,  but  has  gone  to  the  former 
stockholders  of  the  subsidiary.  Nevertheless,  it  is  an  actual 
investment  by  the  parent  company  just  as  much  as  though  the 
subsidiary  had  first  been  dissolved  and  its  assets  distributed 
and  then  bought  by  the  parent  company. 

The  parent  company  would  presumably  not  pay  more  than 
the  book  value  of  the  subsidiary  stock  unless  the  subsidiary 
had  some  assets,  or  an  earning  power  which  in  turn  creates  an 
intangible  asset,  warranting  the  payment  of  more  than  the 
value  at  which  its  assets  appear  on  the  subsidiary's  books. 
Therefore,  inasmuch  as  the  stock  of  the  subsidiary  carries 
with  it  ownership  and  control  of  such  assets,  the  parent  com- 
pany is  making  an  investment  based  upon  the  actual  value  of 
the  assets  of  the  subsidiary  at  the  time  of  the  acquisition  of 
its  stock.  Also,  while  there  is  nothing  in  the  191 8  law  which 
would  seem  to  forbid  treating  such  excess  payment  for  stock 
in  a  subsidiary  as  a  part  of  the  consolidated  invested  capital, 
it  would  seem  entirely  proper,  and  indeed  be  required  by  Sec- 
tion 326  (a-2),  that  in  determining  the  invested  capital  of  a 
parent  corporation  the  full  amount  paid  for  the  stock  of  a 
subsidiary  should  be  included.  There  is  no  requirement  or 
even  intimation  in  the  section  mentioned  that  any  deduction 
should  be  made  from  the  parent  company's  or  the  consolidated 
invested  capital  because  the  amount  paid  for  the  stock  of  a 
subsidiary  may  exceed  the  book  value  of  the  stock. 

In  considering  the  other  side  of  the  question  just  under 


CONSOLIDATED     RETURNS 


211 


discussion,  that  is,  whether  in  the  event  of  the  stock  of  a 
subsidiary  being  acquired  by  the  parent  company  for  less  than 
the  book  value  of  the  former  at  the  time  of  acquirement,  the 
first  inclination  might  be  to  say  that  naturally  whatever  rule 
has  been  laid  down  for  one  case  should  apply  conversely  when 
the  reverse  condition  is  found.    This  is  evidently  the  position 
taken  by  the  Treasury,  as  is  seen   from  articles    867  and 
868  which  have  been  quoted  on   page  209.  A  strong  argu- 
ment is  to  be  made  for  this  view  of  the  situation.    The  stock- 
holders of  the  subsidiaries  no  longer  have  an    investment 
therein ;  the  capital  of  the  parent  company  now  represents  the 
capital  invested ;  the  group  of  companies  being  treated  as  an 
economic   unit,  the  effect  of  the  acquisition  of  the  stock  of 
one  or  more  subsidiaries  was  tantamount  to  the  dissolution  of 
such  companies  and  the  purchase  of  their  properties  and  other 
assets  at  their  then  value. 

In  other  words,  a  new  deal  has  been  made  and,  if  the  stock 
has  been  acquired  for  less  than  its  book  value,  it  is  a  bargain 
purchase  and  the  transaction  should  be  so  treated  in  determin- 
ing  the  consolidated  invested  capital.  Further,  any  minority 
interest  of  the  stockholders  of  subsidiaries  is  permitted  to  be 
included  in  the  consolidated  invested  capital,  presumably 
on  the  basis  of  the  invested  capital  of  such  subsidiaries  prior 
to  their  acquisition  by  the  parent  company.  Article  864 
of  Regulations  45  reads  in  substance  that 

In  computing  consolidated  invested  capital  the  starting  point  is  fur- 
nished by  the  total  of  the  amounts  shown  under  (a)  the  capital  stock  of 
the  parent  or  principal  company  in  the  hands  of  the  public;  (6)  the 
consolidated  surplus  belonging  to  the  stockholders  of  the  parent  or 
principal  company;  and  (c)  the  capital  stock  if  any.  of  subsidiary  com- 
panies not  owned  by  the  parent  or  principal  company,  together  with 
the  surplus,  if  any,  belonging  to  such  minonty  interest. 

A  strong  argument,  however,  is  also  to  be  made  for  includ- 
ing in  the  consolidated  invested  capital  the  full  invested 
capital  which  can  be  shown  for  a  subsidiary  on  the  basis  of 
the  original  investment  therein  (together  with  subsequent 
accumulations)  regardless  of  the  fact  that  later  the  parent 
company  may  have  acquired  the  stock  for  less  than  book 
value.    While  it  is  often  said  that  it  is  a  poor  rule  which  does 


i'. 


p 


212       COLUMBIA     INCOME     TAX     LECTURES 

not  work  both  ways,  and  in  a  general  way  this  may  be  said 
to  be  true,  it  can  easily  be  demonstrated  that  there  are  excep- 
tions. Those  who  used  one  of  the  earlier  editions  of  Went- 
worth's  Geometry  may  remember  the  illustration  given  to 
demonstrate  that  the  converse  of  a  proposition  is  not  neces- 
sarily true.  The  illustration  was  that  all  horses  are  quadrupeds, 
but  not  all  quadrupeds  are  horses. 

It  will  also  come  to  the  mind  of  the  experienced  accountant 
that  while  he  holds  it  to  be  a  sound  principle  that  when  market 
values  are  less  than  cost,  inventories  shall  be  taken  at  market, 
he  does  not  concede  that,  when  market  is  higher  than  cost, 
market  should  still  be  used.  It  is  recognized  that  while  the 
principle  of  valuing  inventories  at  cost  or  market,  whichever 
is  lower,  may  not  be  defensible  from  the  standpoint  of  pure 
logic,  there  are  nevertheless  very  good  practical  reasons  why 
it  should  be  adhered  to  and,  as  already  pointed  out,  the 
Treasury  has  finally  come  to  recognize  that  this  is  the  case. 
Therefore,  in  approaching  the  question  now  before  us,  we 
should  do  it  with  a  mind  free  to  look  at  the  merits  of  the  case 
regardless  of  what  our  decision  was  when  the  conditions  were 
just  the  reverse  of  those  we  are  about  to  consider. 

When  a  parent  company  acquires  the  stock  of  a  subsidiary 
which  is  still  continued  as  a  separate  legal  entity,  the  parent 
company   succeeds  to   the   rights  of  the   former  individual 
stockholders   and,    if   the    invested    capital    as   legitimately 
determined  for  the  subsidiary  company  as  a  separate  entity  is 
not  affected  by  the  changing  of  its  stockholders  (if  individuals), 
it  would  seem  it  ought  not  to  be  decreased  for  purposes  of 
consolidation  with  the  parent  company  merely  because  the 
latter  may  have  acquired  the  stock  of  the  subsidiary  for  less 
than  its  book  value.      If  there  was  originally  a  bona  fide 
investment  by  the  former  individual  stockholders  of  the  sub- 
sidiary which,  at  the  time  of  acquisition  by  the  parent  com- 
pany, still  shows  a  legitimate  invested  capital  in  excess  of 
cost  of  the  latter,  the  relation  of  earnings  to  invested  capital 
contemplated  by  the  excess  profits  tax  act  would  appear  to 
be  fairly  on  the  basis  of  the  present  earnings  compared  with 
the  bona  fide   capital  invested  and  still   remaining    in    the 


CONSOLIDATED     RETURNS 


213 


i 
i 


business.  When  the  individual  stockholders  sold  their  stock 
to  the  new  parent  corporation  they  took  nothing  from  the 
invested  capital  of  the  subsidiary,  and  the  parent  company 
would  seem  entitled  to  make  a  bargain  purchase  just  as  any 
individual  stockholder  of  the  subsidiary  might  have  made 
when  he  acquired  his  stock.  It  will  doubtless  be  readily  con- 
ceded that  such  bargain  purchase  by  an  individual  stock- 
holder could  not  have  operated  to  reduce  the  admissible 
invested  capital  of  the  company  whose  stock  he  purchased. 

In  passing  it  might  be  pointed  out,  too,  that  in  those  cases 
where  the  parent  company  has  paid  more  than  the  book  value 
of  the  subsidiary  the  excess  investment  is  in  reality  a  part  of 
the  invested  capital  of  the  parent  company,  whereas  in  those 
cases  where  the  parent  company  has  paid  less  than  the  book 
value  of  the  subsidiary  stock  the  difference  is  in  reality  in- 
vested capital  of  the  subsidiary,  and  in  both  cases  the  parent 
company  and  the  subsidiary  company,  respectively,  are 
entitled  to  contribute  to  the  calculation  of  the  consolidated 
invested  capital  the  full  amount  of  their  invested  capital 
utilized  in  the  business  "of  the  entire  group  treated  as  one  unit 
operated  under  a  common  control."  ^* 

In  cases  where  several  corporations  are  wholly  owned  by  a 
partnership,  an  individual  or  a  syndicate,  and  thus  are  re- 
quired under  Section  240  to  file  consolidated  returns,  the 
invested  capital  allowed  each  of  these  affiliated  corporations 
is  not  dependent  (except  in  the  case  of  original  subscriptions 
for  stock)  on  what  amount  was  paid  by  the  partnership, 
individual  or  syndicate  for  the  stock  of  any  one  of  these 
companies.  Equity  and  consistency  would,  in  the  absence 
of  any  specific  law  requirement  to  the  contrary,  decree  that 
like  treatment  should  be  accorded  affiliated  corporations 
which  have  this  relationship  because  of  their  common  owner- 
ship by  a  parent  corporation  instead  of  by  a  partnership, 
individual  or  syndicate. 

It  is  conceded  that  if,  instead  of  buying  stock  of  the  sub- 
sidiary, the  parent  company  had  purchased  part  or  all  of  its 
assets,  only  the  amount  paid  would  be  allowed  as  invested 

>«  Art.  864. 


214      COLUMBIA     INCOME     TAX     LECTURES 

capital  regardless  of  the  investment  by  the  preceding  owner. 
This,  however,  is  not  an  argument  for  including  in  the  con- 
solidated invested  capital  the  investment  by  the  subsidiary 
at  only  the  amount  paid  for  its  stock  by  the  parent  corpora- 
tion. When  specific  property,  other  than  capital  stock, 
changes  hands,  the  purchaser,  even  though  he  has  made  a 
bargain  purchase,  cannot  value  for  invested  capital  purposes 
such  assets  purchased  at  more  than  their  cost  to  the  purchasing 
company.  If  the  stock  of  a  company  changes  hands,  how- 
ever, there  has  legally  not  been  a  transfer  of  the  assets  owned 
by  the  company  but  merely  an  evidence  of  changing  interest 
in  the  company.  It  would  seem  to  be  the  intent  of  the  excess 
profits  tax  act  that,  so  long  as  the  corporate  existence  is 
maintained,  its  invested  capital  shall  continue  to  be  deter- 
mined in  the  same  manner  regardless  of  changes  among  the 
holders  of  its  capital  stock.  When,  however,  the  corporation 
is  dissolved  or  specified  assets  are  otherwise  alienated  from 
the  corporation,  the  new  owner's  investment  in  such  assets 
must  form  the  basis  of  invested  capital  if  such  new  owner 
is  subjected  to  excess  profits  tax. 

The  general  intent  of  the  permission  granted  by  Section  240 
of  the  191 8  act  for  consolidated  returns  by  affiliated  corpora- 
tions was  evidently  to  confer  a  boon  and  not  to  impose  a 
penalty.  This  is  evidenced  by  the  provision  prohibiting  the 
inclusion  in  a  consolidated  return  of  the  operations  of  a  cor- 
poration organized  after  August  i,  1914,  and  deriving  its 
principal  income  from  war  contracts.  To  require  the  elimina- 
tion of  a  part  of  the  actual  invested  capital  of  a  subsidiary 
company  merely  because  it  exceeded  the  purchase  price  paid 
by  the  present  owner  of  its  stock  would,  however,  be  imposing 
a  penalty  on  the  consolidation.  In  place,  however,  of  any 
intent  to  impose  penalties  on  parent  companies,  the  191 8  act 
on  the  contrary  eliminated  the  discriminatory  two  per  cent, 
income  tax  which  holding  or  parent  companies  had  by  former 
laws  been  required  to  pay  on  dividends  received  by  them  from 
their  subsidiaries. 

Before  leaving  this  subject,  the  question  may  be  raised  as 
to  what  the  attitude  of  the  Treasury  would  be  in  the  event  of  a 


CONSOLIDATED     RETURNS 


215 


subsidiary  with  a  capital  stock  and  book  surplus  of,  say, 
$1,000,000,  whose  capital  stock  was  purchased  by  a  parent 
company  for,  say,  $800,000,  selling  its  plant  or  otherwise  con- 
verting its  assets  so  that  they  would  indisputably  be  in  cash 
or  its  equivalent  amounting  to  $1,000,000.  For  the  purposes 
of  the  illustration  it  is  assumed  that  all  the  earnings  of  the 
subsidiary,  subsequent  to  acquirement  of  its  stock,  have  been 
paid  over  to  the  parent  company. 

The  conversion  of  assets  into  cash  or  its  equivalent  would 
result  in  no  profit  to  the  subsidiary,  as  the  realization  does 
not  exceed  the  book  value  of  the  assets.  Neither  has  any 
taxable  income  been  received  by  the  parent  company;  if  no 
part  of  the  $1,000,000  has  been  paid  over  to  the  parent  com- 
pany there  has  been  merely  an  appreciation  in  the  value  of  the 
subsidiary's  stock  held  by  the  parent  company,  and  if  $200,000 
(excess  of  $1,000,000  cash  or  equivalent  over  cost  of  $800,000) 
had  been  paid  to  the  parent  company  as  a  dividend,  it  would 
not  be  taxable  to  the  parent  company. 

Under  the  Treasury  regulations  already  quoted,^  the  con- 
solidated invested  capital  would  include  only  $800,000  for 
the  subsidiary.  Since  this  is  the  actual  investment  by  the 
parent  company  there  is  some  argument  for  using  it,  but  when 
the  assets  of  the  subsidiary  clearly  amount  to  $1,000,000  in 
cash  or  its  equivalent  it  seems  absurd  to  say  that  the  invested 
capital  for  the  subsidiary  is  only  $800,000.  Just  when  the 
additional  $200,000  should  be  added  to  the  invested  capital, 
admitting  for  sake  of  discussion  that  the  Treasury  regulation 
is  reasonable  under  ordinary  circumstances,  offers  the  diffi- 
culty. The  thought  is  offered  for  consideration  that  there  is 
some  analogy  between  a  case  such  as  that  described  and  one 
in  which  appreciation  accrued  prior  to  March  i,  1913,  is 
realized.  Until  realization,  such  appreciation  cannot  be 
included  in  invested  capital.  After  realization,  however,  even 
though  it  is  not  taxable,  the  appreciation  may  be  included  in 
invested  capital.  Similarly,  after  the  difference  between  the 
invested  capital  of  the  subsidiary  as  a  separate  entity  and  the 
price  paid  for  its  stock  by  the  parent  company  has  been 

*  Regulations  45,  Arts.  867  and  868. 


•K..  1 


t| 


2l6      COLUMBIA     INCOME     TAX     LECTURES 

realized  in  cash  or  its  equivalent,  it  would  appear  to  be  a 
proper  item  for  inclusion  in  the  consolidated  invested  capital. 
Pre-war  Consolidated  Invested  Capital.  While  pre-war  invested 
capital  and  income  have  a  bearing  on  but  few  of  the  returns 
now  being  made,  the  questions  connected  with  their  deter- 
mination are  still  of  importance  because  of  the  many  consoli- 
dated returns  for  191 7  and  191 8  which  are  yet  to  be  audited  by 
the  Treasury.  The  Treasury  regulations  bearing  on  this 
question  read  as  follows: 

The  invested  capital  of  affiliated  corporations  for  the  pre-war  period 
shall  be  computed  on  the  same  basis  as  the  invested  capital  for  the 
taxable  year,  except  that  where  any  one  or  more  of  the  corporations  in- 
cluded in  the  consolidation  for  the  taxable  year  were  in  existence  during 
the  pre-war  period,  but  were  not  then  affiliated  as  herein  defined,  then 
the  average  consolidated  invested  capital  for  the  pre-war  period  shall  be 
the  average  invested  capital  of  the  corporations  which  were  affiliated 
in  the  pre-war  period  plus  the  aggregate  of  the  average  invested  capital 
for  each  of  the  several  corporations  which  were  not  affiliated  during  the 
pre-war  period.  Full  recognition,  however,  must  be  given  to  the  provi- 
sions of  section  330  of  the  statute,  particularly  the  last  paragraph  there- 
of "2* 

Section  330  of  the  statute  deals  with  the  determination  of 
pre-war  invested  capital  and  pre-war  income  "in  the  case  of  the 
reorganization,  consolidation,  or  change  of  ownership  after 
January  i,  19 11,  of  a  trade  or  business  now  carried  on  by  a 
corporation."  The  intent  of  the  section  is  "to  place  the  com- 
putation of  the  (pre-war)  invested  capital  ...  on  the  basis 
employed  in  determining  the  invested  capital  for  the  tcixable 
year. 

The  regulations  quoted  above  refer  to  computing  the  pre- 
war invested  capital  of  those  companies  which  were  affiliated 
in  the  pre-war  period  and  also  those  corporations  which  were 
subsequently  acquired  and  consolidating  them  to  determine 
invested  capital  for  pre-war  period.  No  mention  is  made, 
however,  of  what  should  be  done  in  computing  pre-war  invested 
capital  or  income  if  one  company  of  the  group  went  out  of 
existence  or  was  sold  subsequent  to  the  pre-war  period.  From 
an  ideal  standpoint  it  would  be  desirable  to  state  the  pre-war 
invested  capital  on  the  same  basis  as  for  the  taxable  period, 

»  Art.  869. 


CONSOLIDATED     RETURNS 


217 


i.  e.,  eliminating  from  the  pre-war  figures  those  of  the  sub- 
sidiary which  is  no  longer  in  the  group. 

The  elimination  of  the  pre-war  income  of  the  subsidiary 
would  be  a  simple  matter  but  not  so  as  to  the  invested  capital. 
What  corresponding  elements  are  to  be  eliminated  from  the 
parent  company's  balance  sheet  when  eliminating  the  invest- 
ment in  the  subsidiary?  Is  an  amount  corresponding  to  the 
investment  in  the  subsidiary  to  be  eliminated  from  the  capital 
stock  and  surplus  of  the  parent  company?  Or,  is  the 
elimination  to  be  made  from  the  liabilities  of  the  parent 
company  on  the  assumption  that  the  proceeds  of  the 
sale  or  dissolution  of  the  subsidiary  have  in  effect  been 
used  to  reduce  the  parent  company's  liabilities?  Or,  are 
the  proceeds  simply  to  be  considered  as  increasing  the 
current  assets  of  the  parent  company?  Each  of  these 
methods  would   have   a  different  effect  on  the  consolidated 

invested  capital. 

Any  one  of  the  above  mentioned  methods  offers  difficulties 
of  application.  From  a  practical  standpoint,  it  would  seem 
best  not  to  attempt  to  eliminate  the  subsidiary  in  determining 
the  pre-war  invested  capital  of  the  group  and  to  allow  the 
adjustment  to  come  through  that  section  of  the  law  which 
provides  that  in  determining  the  war  profits  credit  there  shall 
be  added  or  deducted  from  the  average  pre-war  income  "10  per 
centum  of  the  difference  (increase  or  decrease,  respectively) 
between  the  average  invested  capital  for  the  pre-war  period 
and  the  invested  capital  for  the  taxable  year.*^  In  determining 
the  average  pre-war  earnings  for  purposes  of  the  191 7  excess 
profits  exemption,  it  would  seem  fair  to  compare  the  pre-war 
earnings  with  invested  capital  of  the  companies  then  owned 
and  of  any  since  acquired. 

Losses  in  Pre-war  Period.  Another  question  which  apparently 
was  not  considered  in  the  Treasury  regulations  is  how  losses 
in  the  pre-war  period  were  to  be  applied  in  the  case  of  consoli- 
dated returns. 

In  the  1 91 8  Excess  Profits  Tax  Primer  there  is  a  question 
and  answer  (number  15)  which  refers  to  pre-war  losses  in  the 

"  1918  law,  section  3"  (a-a). 


t 


7 


2l8      COLUMBIA     INCOME     TAX     LECTURES 

case  of  a  single  company.  If  the  company  had  profits  in  two 
years  and  a  loss  in  the  other  year  of  the  pre-war  period,  the 
Treasury  held  that  the  loss  of  one  year  need  not  be  applied 
against  the  profits  of  the  other  years.  In  the  illustration  given 
in  the  Primer,  the  profits  of  the  two  years  are  added  and  the 
sum  divided  by  three  to  determine  the  average  annual  profits 
of  the  pre-war  period.  It  was  stated  that  "the  loss  ...  is 
disregarded  inasmuch  as  the  income  tax  law  does  not  permit 
the  loss  of  one  year  to  affect  or  reduce  the  profit  of  another 
year." 

Now  the  question  is  whether  the  above  mentioned  illustra- 
tion is  to  be  used  as  a  guide  and  the  average  pre-war  income 
determined  for  a  group  of  affiliated  corporations  in  the  same 
manner.  If  so,  the  taxable  income  reported  by  the  various 
affiliated  companies  during  the  pre-war  period  would  be  aggre- 
gated and  (without  making  any  deduction  for  losses  which 
some  of  the  companies  may  have  sustained  during  one  or  more 
of  the  pre-war  years)  the  total  divided  by  three  to  ascertain 
the  average  consolidated  pre-war  income. 

If,  following  the  Treasury's  reasoning  in  the  Primer,  a  group 
of  aiBliated  corporations  showed  a  net  loss  for  one  or  two  years 
of  the  pre-war  period,  such  loss  would  not  have  to  be  deducted 
from  the  net  profit  of  the  group  for  the  other  years  in  calculat- 
ing the  average  pre-war  income.  The  law  still  makes  no  pro- 
vision 28  for  offsetting  losses  of  one  year  against  the  profits  of 
other  years.  Therefore,  while  losses  of  one  company  may  now, 
in  making  a  consolidated  return,  be  applied  against  the  profits 
of  an  affiliated  company  in  the  same  year,  the  latest  act  still 
does  not  permit  a  net  loss  of  the  group  for  one  year  to  be 
applied  against  the  net  profit  of  the  group  for  another  year. 

Since,  however,  profits  and  losses  may,  since  191 8  as  to  both 
income  and  profits  taxes,  and  since  191 7  as  to  excess  profits 
tax,  be  offset  in  a  consolidated  return,  must  they  be  offset  in 
the  pre-war  period?  Let  us  assume  that  three  affiliated 
companies  showed  the  following  results  during  the  pre-war 
period: 

«•  Excepting  for  one  ipecific  period.  C/.  1918  law,  •ectiona  104  (b).  ai4  (la)  and  934 
(14). 


CONSOLIDATED     RETURNS 


219 


Company 
A 
B 
C 


Consolidated 
iQii  1912  1913  {Net  Profit) 

Profit  f  50,000  Loss  ^10.000  Profit  ^40,000  $  80,000 
Loss  10,000  Profit  50,000  Profit  60,000  100,000 
Profit    50,000    Profit    50,000     Loss       10,000         90,000 


Annual    net 
profit 


^90,000 


^90,000 


Average  pre-war  income 


^90,000       ^270,000 
1/3  90tOOO 


If  losses  are  to  be  applied  against  profits  of  the  same  years, 
the  average  pre-war  income  for  the  group  would  be,  as  above, 

$90,000. 

Suppose,  however,  that  the  losses  all  occurred  in  one  year 
and  that  the  same  total  net  profit  had  been  earned  in  the  pre- 
war years  as  follows: 

jgji  igi2  1913      Consolidated 

Company  (Profits)  (Losses)  (Profits)  (Net  Profit) 

A  -?50,ooo  ^10,000  ^40,000      ^80,000 

B  50,000  10,000  60,000      100,000 

C  50,000  10,000  50,000        90,000 


Annual    net  ^  ^    r     »  <r  -    ...v^ 

result— Profit  ^150,000    Loss   ^30.000  Profit  ^i  50.000    ^270,000 


Average  pre-war  income  i  /3 


90,000 


Following  the  Treasury's  reasoning,  the  pre-war  consolidated 
income  would  in  the  latter  illustration,  be  not  $90,000  but 
$100,000.  The  later  figure  is  the  sum  of  the  profits  for  191 1 
and  19 1 3  divided  by  three. 

Is  there  any  more  reason  for  holding  the  pre-war  consolidated 
income  to  have  been  $100,000  in  the  one  case  than  in  the  other? 

This  is  but  another  illustration  of  the  fact  that  mere  accident 
often  plays  an  important  part  in  the  determination  of  the 
amount  of  excess  profits  tax  payable  by  a  taxpayer. 

Stock  Dividends,  Stock  dividends  of  subsidiary  corporations 
to  the  parent  company  would,  of  course,  make  no  change  in  the 
consolidated  invested  capital,  and  similarly  stock  dividends  of 
the  parent  company  to  its  stockholders  would  not  effect  any 
change  in  the  conslidated  invested  capital. 

Change  in  Ownership  during  Taxable  Year.  The  Treasury 
gives  no  instructions  to  be  followed  in  such  a  case,  merely 


220       COLUMBIA     INCOME     TAX     LECTURES 

saying  that  in  the  case  of  new  subsidiaries  acquired,  or  com- 
panies becoming  affiliated  during  the  year  through  common 
ownership,  or  vice  versa,  full  statement  shall  be  made  of  the 
facts  to  the  Commissioner  and  he  may,  in  accordance  with  the 
peculiar  circumstances  in  each  case,  require  either  separate  or 
consolidated  returns  to  be  filed,  to  the  end  that  tax  may  be 
equitably  assessed.^' 

It  would  appear  that  either  separate  or  consolidated  returns 
should  be  filed,  according  to  which  seemed  warranted  by  the 
circumstances  of  the  case.  In  due  course  the  return  or  returns 
will  be  reviewed  by  the  Commissioner  and  final  determination  of 
the  question  then  be  had.  Either  the  returns  filed  will  be  defin- 
itely accepted  or  the  filing  of  amended  returns  will  be  required. 

In  one  case  of  changing  affiliations  during  the  taxable  year 
which  came  to  the  writer's  attention,  a  consolidated  return 
was  made  for  the  entire  year,  though  the  companies  became 
affiliated  only  during  the  year,  with  substantial  justice  result- 
ing to  both  the  corporations  and  the  Government.  The  facts 
in  the  case,  very  briefly  stated,  were  that  a  mercantile  company 
during  the  year  increased  its  capital  stock,  got  new  money 
into  the  business,  and  purchased  two  other  companies'  manu- 
facturing goods  like  those  sold  by  the  mercantile  company.  A 
consolidated  return  was  made  for  the  calendar  year,  the 
invested  capital  of  the  mercantile  company  being  computed 
for  the  entire  year.  This  in  effect  included  the  invested  capital 
of  only  the  parent  company  merely  to  the  time  the  subsidiaries 
were  acquired  and  the  capital  invested  in  the  operations  of 
all  three  companies  after  they  became  affiliated.  There  was 
then  added  thereto  the  invested  capital  of  each  of  the  sub- 
sidiaries (the  two  manufacturing  companies),  computed 
separately  for  the  fractional  part  of  the  year  which  had  elapsed 
before  they  were  acquired  by  the  parent  company.  This 
gave  the  consolidated  invested  capital,  which  served  as  the 
basis  for  determining  the  excess  profits  tax  to  be  paid  on  the 
aggregate  taxable  income  of  the  three  companies  for  the  entire 
year.  This  way  of  handling  the  situation  seemed  to  result 
in  substantial  justice  in  this  particular  case. 

"  Art.  634. 


CONSOLIDATED     RETURNS 


221 


Different    Fiscal    Years    of    Corporations.      The    following 

regulation  deals  with  the  question  of  the  period  for  which  a 

consolidated  return  is  to  be  made : 

In  the  case  of  all  consolidated  returns,  consolidated  invested  capital 
must  be  computed  as  of  the  beginning  of  the  taxable  year  of  the  parent 
or  principal  repoiting  company  and  consolidated  mcome  must  be 
computed  on  the  basis  of  its  taxable  year.  Whenever  the  fiscal  year 
of  one  or  more  subsidiary  or  other  affiliated  corporations  differs  from 
the  fiscal  year  of  the  parent  or  principal  corporation,  the  Commissioner 
should  be  fully  advised  by  the  taxpayer  in  order  that  provision  may  be 
made  for  assessing  the  tax  in  respect  of  the  period  prior  to  the  beginning 
of  the  fiscal  year  of  the  parent  or  principal  company.'® 

Exemptions.  In  the  case  of  the  specific  $3,000  war  and 
excess  profits  credit  and  the  $2,000  income  exemption,  re- 
spectively, the  1918  law  definitely  provides  that  only  one 
exception  of  $3,000  for  war  and  excess  profits  credit  and  one 
$2,000  income  exemption  shall  be  allowed  to  a  group  of 
affiliated  companies  making  a  consolidated  return. 

The  act  does  not  state  whether  the  Liberty  bond  exemptions 
shall  be  allowed  to  each  company  separately  or  only  one  set  of 
exemptions  to  the  group  as  a  whole.  The  Treasury,  however, 
has  held  that: 

Each  of  several  affiliated  corporations  ...  is  entitled  to  the 
same  full  benefits  under  the  exemption  provisions  of  the  several 
Liberty  bond  acts  to  which  it  would  be  entitled  if  not  affiliated.'^ 

Information  Returns.    It  is  to  be  borne  in  mind  that : 

Corporations  which  are  affiliated  within  the  meaning  of  Section  240 
of  the  Revenue  Act  of  19 18  are  required  to  make  a  consolidated  return 
of  net  income  and  invested  capital,  but  they  will  not  be  permitted  to 
file  a  consolidated  return  of  information  at  the  source.  Each  corpora- 
tion must  file  a  separate  return  of  information  as  required  by  Section 
256."  » 

»  Art.  638. 

>»  Income  Tax  Rulings,  12-19-171. 

«Ibid..  i6-ao-868. 


|. 


THE  TAXATION  OF  INCOME  FROM  NATURAL 

RESOURCES 

BY 

R.  V.  NoRRis,  E.M.,  M.Sc. 

The  imposition  by  the  United  States  Government  of  income 
and  excess  profits  taxes,  dating  from  the  adoption  of  the  Six- 
teenth Amendment  to  the  Constitution,  February  25,  1913, 
has  forced  much  more  careful  analysis  of  values  and  of  income 
than  was  previously  necessary.  This  is  particularly  the  case 
with  the  industries  based  on  wasting  natural  resources,  in 
which  the  raw  material  is  either  irreplaceable  as  in  the  case  of 
mineral,  oil  and  gas,  or  so  slowly  replaceable  as  timber,  as  to 
be  classed  with  these. 

The  importance  of  this  source  of  taxation  is  evidenced  by 
the  fact  that  the  mineral  and  metal  industries  paid  in  191 6, 
34.5  per  cent,  and  in  191 7,  35.1  per  cent,  of  the  total 
taxes  paid  by  corporations   (Graton,  A.I.M.E.,  September, 

1919)- 
The  principles  involved  in  the  taxation  of  these  wasting 

assets,  while  in  general  the  same  as  for  other  taxation,  diflfer 

in  the  necessity  for  a  depletion  allowance  as  distinguished  from 

depreciation  or  amortization.    The  Revenue  Act  of  191 8,  Part 

I,  Section  214  (a)  (10),  reads  as  follows: 

In  the  cases  of  mines,  oil  and  gas  wells,  other  natural  deposits,  and 
timber,  a  reasonable  allowance  for  depletion  and  for  depreciation  of 
improvements,  according  to  the  peculiar  conditions  in  each  case,  based 
upon  cost  including  cost  of  development  not  otherwise  deducted: 
Provided,  That  in  the  case  of  such  properties  acquired  prior  to  March 
I,  1913,  the  fair  market  value  of  the  property  (or  the  taxpayer's  interest 
therein)  on  that  date  shall  be  taken  in  lieu  of  cost  up  to  that  date: 
Provided  Further,  That  in  the  case  of  mines,  oil  and  gas  wells,  dis- 
covered by  the  taxpayer,  on  or  after  March  i,  1913,  and  not  acquired 
as  the  result  of  purchase  of  a  proven  tract  or  lease,  where  the  fair 
market  value  of  the  property  is  materially  disproportionate  to  the  cost, 
the  depletion  allowance  shall  be  based  upon  the  fair  market  value  of 


INCOME    FROM    NATURAL    RESOURCES         223 

the  property  at  the  date  of  the  discovery,  or  within  thirty  days  there- 
after; such  reasonable  allowance  in  all  the  above  cases  to  be  made 
under  rules  and  regulations  to  be  prescribed  by  the  Commissioner  with 
the  approval  of  the  Secretary.  In  the  case  of  leases  the  deductions 
allowed  by  this  paragraph  shall  be  equitably  apportioned  between  the 
lessor  and  lessee. 

This  language  is  repeated,  Part  II,  A,  Section  234  (a)  (9). 
applying  to  corporations.  It  is  under  this  section  that  the 
income  from  the  wasting  industries  is  differentiated  from  all 
other  income,  in  that  depletion  deductions  are  allowed. 

The  rules  and  regulations  referred  to  in  the  law  "to  be 
prescribed  by  the  Commissioner"  are  embodied  in  Treasury 
Regulations  45,  Articles  201  to  235  inclusive.  These  regula- 
tions have  the  force  of  law,  in  fact  are  a  part  of  the  law.  How- 
ever, they  are  amended  from  time  to  time  and  also  modified  in 
accordance  with  Court  decisions,  so  that  it  is  practically 
impossible  to  discuss  this  matter  with  assurance  that  the  data 
presented  are  fully  up  to  date,  and  most  inadvisable  to  rely 
on  even  relatively  recent  publications  for  the  present  status 
of  the  law.*  As  a  matter  of  fact  it  has  been  necessary  to 
recast  this  entire  paper  to  take  into  account  the  revised  rulings, 
approved  December  29,  1920. 

Capital.  The  law  and  the  regulations  bring  up  sharply  a  dis- 
tinction drawn  between  invested  capital  of  the  excess  profits 
tax  (Sec.  326)  and  value  for  depletion  (Sec.  214).  Invested 
capital  (Art.  831)  is  defined  as  "the  capital  actually  paid 
in  to  the  corporation  by  the  stockholders,  including  surplus 
and  undivided  profits,  and  is  not  based  on  the  present  net  • 
worth  of  the  assets  as  shown  by  appraisal  or  in  any  other 

manner." 

As  applied  to  the  wasting  industries  the  definition  of  in- 
vested capital  seems  unfair;  it  is  an  undisputed  fact  that 
the  values  of  operating  mines,  oil  and  gas  wells,  etc.,  bear 
but  little  relation  to  the  actual  cost.  A  developed  and  oper- 
ating property  may  well  have  a  market  value  far  greater  than 
the  sum  of  the  cost  of  the  undeveloped  property  and  of  the 
capitalized  cost  of  development. 

» In  the  following  references  to  Sections  refer  to  the  law  and  to  Articles  to  Regula- 
tions 45.  With  respect  to  the  legal  force  and  efiEect  of  these  regulations,  cf.  supra,  p.  91  d  seq. 


I.j 


'i 


I 


224      COLUMBIA     INCOME     TAX     LECTURES 

This  matter  was  carefully  studied  by  the  Committee  on  the 
Federal  Taxation  of  Mines  of  the  American  Institute  of  Mining 
and  Metallurgical  Engineers,  who  in  their  report  recommended 
that  Article  838  be  amended  by  adding : 

But  in  the  case  of  mines  and  mineral  deposits,  where  legitimate 
expenditures  have  been  made  for  the  purpose  of  developing  known  ore 
bodies,  or  mineral  deposits,  and  ascertainable  values  have  been  added 
to  the  property,  or  where,  as  a  result  of  development  undertaken,  ex- 
ploration conducted,  or  the  adaptation  of  improved  processes,  deposits 
or  portions  thereof  unknown  or  without  value  at  the  date  when  the 
mining  property  was  acquired,  or  which  were  not  then  susceptible  of 
most  efficient  beneficiation,  have  been  developed  and  given  a  value  or 
an  additional  value  which  can  be  ascertained  with  reasonable  accuracy, 
such  value  or  additional  value  shall  be  regarded  as  surplus  and  shall 
be  included  in  invested  capital;  such  earned  value  not  being  "value 
appreciation"  within  the  meaning  of  the  last  paragraph  of  Article  844. 

It  does  not  seem  logical  that  invested  capital  should  be 
limited  to  the  original  cost,  and  in  allowing  depletion  on  revalu- 
ations the  law  practically  acknowledges  this.  It  can  hardly 
be  contended  for  instance  that  the  value  of  a  large  area  of  the 
anthracite  lands  of  the  Lehigh  Coal  &  Navigation  Company 
is  represented  by  the  "ear  of  corn,"  the  consideration  of  a  deed 
made  over  a  century  ago,  nor  that  an  area  of  timberland  pur- 
chased generations  ago  at  a  nominal  value  is  now  worth  no 
more  than  when  it  was  in  an  inaccessible  wilderness.  Further,  a 
sale  may  easily  increase  many  times  the  invested  capital  in  a 
property,  but  it  does  not  change  the  value  of  the  property. 

If  any  invested  capital  is  to  be  considered  it  seems  only 
proper  that  this  should  represent  value. 

Depletion.  The  value  of  a  property  for  depletion  is  treated 
as  above  noted  in  Sections  214  (a)  (10)  and  234  (a)  (9)  and  by 
Articles  201  to  235  inclusive. 

It  is  perhaps  most  logical  to  discuss  this  phase  of  the  subject 
in  the  order  in  which  it  is  treated  in  the  "Regulations." 

Article  201.  "Depletion  of  Mines,  Oil  and  Gas  Wells"  is  a 
general  statement  of  the  base  for  depletion  deductions.  It 
reads  in  part: 

A  reasonable  deduction  from  gross  income  for  the  depletion  of 
natural  deposits  and  for  the  depreciation  of  improvements  is  per- 
mitted, based 

a.   Upon  cost,    if  acquired  after  February  28,  1913. 


INCOME  FROM  NATURAL  RESOURCES    225 

h.  Upon  the  fair  market  value  as  of  March  i,  1913,  if  acquired 
prior  thereto. 

c.  Upon  the  fair  market  value  within  30  days  after  the  date  of  dis- 
covery in  the  case  of  mines,  oil  and  gas  wells  discovered  by  the 
taxpayer  after  February  28,  1913,  where  the  fair  market  value 
is  materially  disproportionate  to  the  cost.     .     . 

*       «      *      * 

The  intent  being  to  return  the  capital  invested  including  the  cost  of 
plant  and  equipment  and  underground  development  not  chargeable 
to  operating  expense,  or  the  value,  by  the  aggregate  of  annual  deple- 
tion and  depreciation  deductions. 

It  should  be  noted  that  the  cost  is  to  be  returned  by  the 
aggregate  of  annual  allowances,  not  by  a  sinking  fund  with 
allowance  of  interest  on  the  depletion  and  depreciation  charges. 
Articles  202,  203  and  204.  These  three  articles  treat  of  the 
relations  of  lessor  and  lessee  in  respect  to  depletion.  The 
capital  recoverable  through  depletion  allowance  (Art.  202) 
in  the  case  of  an  operating  owner  or  lessor,  and  (Art.  203) 
in  the  case  of  a  lessee  is  defined  thus: 

The  capital  remaining  in  any  year  recoverable  through  depletion 
allowances  is  the  sum  of 

a.   The  cost  of  the  property,  or  its  fair  market  value  as  of  March  i 
1913,  or  its  fair  market  value  within  30  days  after  discovery,  as 
the  case  may  be,  plus 

The  cost  of  subsequent  improvements  and  development  not 
charged  to  current  operating  expenses,  but  minus 
Deductions  for  depletion  which  have  or  should  have  been  taken 

to  date,  and 
d.  The  portion  of  the  capital  account,  if  any,  as  to  which  deprecia- 
tion has  been  and  is  being  deducted  instead  of  depletion. 

The  surface  value  shall  not  be  included,  nor  to  the  lessor 
any  part  of  development  costs  not  borne  by  him,  or  any  part 
of  discovery  value.  The  lessee  is  privileged  to  charge  costs 
in  rents  or  royalties  prior  to  operation  to  either  operating  ex- 
penses, or  to  capital  account,  when  it  "will  form  part  of  the 
capital  returnable  through  depletion". 

Article  204  states  "No  calculation  of  distribution  of  value 
between  lessor  and  lessee  exceeding  the  value  of  the  property 
in  fee  simple  will  be  permitted."  This  should,  we  think,  be  sub- 
ject to  the  exception  that  the  value  based  on  royalties  receiv- 
able is  the  proper  and  practically  the  only  base  for  lessor 
valuations,  and  even  though  the  lessee  may  have  made  a 


h. 


c. 


226      COLUMBIA     INCOME 


TAX     LECTURES 


though  this  may  exceed  the  fee  simple  value.  ' 

1  he  clause  requiring  the  lessor  and  lessee  "to  en„,V.M 
apport,on  the  allowances  on   the  basis  oftheir  rXct^e 

catr    F  "  'l'''"'^  ^"^''  ^"^  ^"'*^  in,practicable   nTppH 

ecu-  b':  mTde  e^S  Zufht  i^in^^flbe-cr  ~ 
some  commission  hav,„g  the  necessary  authority  '       ^ 

bu tto'^rjLT  "?*  *""  ""/""P*  *''"  apportionment  required 

rJ^l     ^^         I  '"*^''^'*'  °^  '^^°^  ^"d  'essee  separately  usi^ 
recognized  methods  of  valuation.  P<*raieiy,  using 

The  amendments  of  December  20   ir>^f>  /^a  .. 
state  that  (h)  «Th»      i        ,  f  "^  ^9.  1920  (Acts  203  and  204) 

Shall  ^^z:^zz:::^:t^,^j-^jtz 
ttrrtLr?tr^''  - -"-"?c;;tr  li 

Le^ts  as  o^r'/n  ?''''"  r  ""'""  °^  '''^  ^^^"'^  °^  other  pay- 
ments as  of  that  date,  or,  ,f  not  leased  on  the  "basic  date  "the 

bloc  value  of  the  mineral,  not  to  exceed  the  present  v2L  of 

royalties  ,f  subsequently  leased.     For  term  E  thrlalue 

.n  the  absence  of  satisfactory  evidence  to  the  S^ran^^wH  .^ 

The  two  estates  of  lessor  and  lessep  in  th^  ^^        c 
"leaspQ"  r^f  »,^^„    I  "  ^"^  ^^^se  of  roya  ty 

decided  by  the  SupZe  Court  orPeL,"  '''"  T*""^ 
T^r  D       /  "piciiie  v^ourt  01  rennsylvania — xi  Pa  47c. 

I'livtT  "^  ^'-  ''■'   '^  P-  583;   123  Pa.  240;  'II, 
fa.,  513,  143  Pa.  293;  240  Pa.  234;  etc 

1-  ui  Liic  lease,  is  held  not  to  constitute  a  sale 


INCOME    FROM    NATURAL    RESOURCES         22^ 

of  coal  in  place,  and  the  royalties  received  are  held  to  be 
income  to  the  lessor,  does  not  seem  to  be  justified. 

Article  205.  Where  the  cost  is  the  basis  for  depletion  (in  the 
case  of  properties  purchased  after  February  28,  191 3),  the 
Treasury  properly  requires  full  proof  of  the  actual  price  paid, 
and  watches  closely  for  fake  sales,  or  for  concealed  or  mis- 
stated prices. 

Article  206.  The  fair  market  value  as  of  the  basic  date 
should  be  that  established,  assuming  a  willing  seller  and  a 
willing  buyer.  "Such  value  may  be  established  by  proper 
evidence  of  market  value,  such  as  cost,  actual  sales  and 
transfers  of  similar  properties,  market  value  of  stock,  royalties 
and  rentals,  values  for  capital  stock  tax,  or  local  taxation, 
records  of  litigation,  probate  court  inventory,  disinterested 
appraisals  by  approved  methods,  and  other  factors." 

It  is  a  matter  of  common  knowledge  that  in  the  case  of 
mines  and  oil  and  gas  wells,  and  to  some  extent  as  to  timber, 
many  of  the  ordinary  evidences  of  value  are  not  good  criteria, 
as  properties  are  not  similar  and  the  value  of  one  does  not 
indicate  the  value  of  its  neighbor.  Of  two  adjacent  mines  one 
may  be  worth  millions  and  the  other  be  a  liability;  of  two 
adjacent  wells,  one  may  be  a  gusher  and  the  other  dry;  one 
timber  lot  may  be  first  growth  pine,  and  the  adjoining  one 
second  growth  hardwood. 

The  other  criteria  suggested  in  the  regulations  are  rarely 
equitably  applicable  in  obtaining  just  valuations  as  between 
"a  willing  seller  and  a  willing  buyer." 

This  was  recognized  by  the  Treasury  Department  when  the 
Subdivision  of  Natural  Resources  was  organized  and  a  careful 
study  of  the  subject  made  and  published  by  Mr.  L.  C.  Graton 
of  the  Treasury,  in  a  paper  entitled  "Federal  Taxation  of 
Mines,"  read  at  the  Chicago  Meeting,  September,  1919,  of  the 
American  Institute  of  Mining  and  Metallurgical  Engineers. 
This  paper  it  was  explained  had  the  approval  of  the  Commis- 
sioner, and  was  regarded  as  a  semi-official  utterance. 

Mr.  Graton  brought  out  the  most  imf)ortant  points  in  con- 
nection with  the  valuation  and  taxation  of  mines:  that 
"increase  in  mine  values  is  not  unearned  increment,"  as  the 


228       COLUMBIA     INCOME     TAX     LECTURES 

work  and  expenditures  merely  develop  what  was  already  in 
the  ground  and  do  not  add  to  values,  as  is  done  to  real  estate 
by  the  growth  of  cities,  improvements  in  transportation,  etc. ; 
that  "exhaustible  capital  values"  must  be  recognized;  that 
allowance  be  made  not  only  for  the  return  of  cost  but  for  the 
replacement  of  exhausted  mineral,  and  that  "mining  must  be  a 
continuing  industry,"  as  the  organizations  built  up  to  work 
mining  properties  successfully  are  of  too  great  economic  value 
to  be  lost  by  the  exhaustion  of  a  single  property.  Mr.  Graton 
finally  points  out  that  most  of  the  properties  have  not  changed 
ownership  since  March  i,  1913,  and  hence  the  valuation  as  of 
that  date  is  the  main  problem. 

After  an  able  discussion  Mr.  Graton  settles  on  the  "Present 
Value  of  Eventual  Earnings"  as  generally  the  most  desirable 
method  of  valuation  for  this  class  of  properties. 

This  method  is  the  usual  engineering  method  of  arriving  at 
values,  and  has  been  illuminated  by  the  writings  of  Hoover 
(Principles  of  Mining,  N.  Y.,  1909)  and  Finlay  (Cost  of  Mining, 
N.  Y.,  1909)  and  is  the  only  definite  method  of  mine  valuation 
expounded  in  the  text  books,  and  used  by  educated  professional 
mining  engineers. 

Further,  this  has  the  authority  of  the  United  States  Supreme 
Court.  In  Cleveland,  Cincinnati,  Chicago  and  St.  Louis  Railway 
Co.,  V.  Backus,  154  U.  S.  439,  the  Court  states: 

But  the  value  of  the  property  results  from  the  use  to  which  it  is 
put  and  varies  with  the  profitableness  of  that  use,  present  and  pro- 
spective, actual  and  anticipated.  There  is  no  pecuniary  value  outside 
of  that  which  results  from  such  use.  The  amount  and  profitable  char- 
acter of  such  use  determines  the  value.     .    , 

This  matter  was  exhaustively  considered  by  the  American 
Institute  of  Mining  and  Metallurgical  Engineers  Mines 
Taxation  Committee,  above  referred  to,  and  they  came  to  the 
same  conclusion,  which  they  reported  as  follows: 

Valuation  of  Mines.  The  committee  arrived  at  the  conclusion 
that  it  would  be  desirable  to  divide  mineral  properties  into  two  classes, 
Class  I  and  Class  II. 

In  Class  I  are  included  mineral  properties  in  which  the  tonnage  or 
other  unit  has  been  determined  with  reasonable  accuracy. 

In  Class  II  are  to  be  included  all  other  deposits. 


INCOME  FROM  NATURAL  RESOURCES 


229 


As  to  Class  I.  The  Committee  considered  methods  of  arriving  at 
the  present  value  of  mineral  property,  and  methods  of  depletion,  and 
has  arrived  at  the  following  conclusions. 

A  proper  value  of  a  mining  property  is  the  present  value  of  the 
prospective  net  earnings  taking  into  account  probable  variations  in 
output  and  value,  discounted  by  recognized  sinking  fund  methods  at 
a  fair  rate  of  interest  with  sinking  fund  at  four  per  cent,  interest,  or  by 
calculations  by  standard  annuity  methods.  But  other  recognized 
methods  of  valuation  acceptable  to  the  Department  may  be  used. 

In  lieu  of  estimated  net  earnings,  where  mining  on  a  royalty  basis 
is  customary,  royalty  prices  may  be  used  in  valuation,  taking  into 
consideration  the  trend  of  such  prices. 

No  mine  shall  be  valued  on  an  estimated  operating  life  exceeding 
forty-five  years. 

Ores  of  different  grades,  location,  and  probable  time  of  extraction 
in  a  mining  property  may  be  classified  separately  and  valued  accord- 
ingly. 

Nothing  herein  contained  shall  be  understood  to  prescribe  a  method 
of  valuing  separately  the  equities  of  lessor  and  lessee  in  a  mining 
property. 

Mines  in  Class  II  may  be  valued  in  the  manner  prescribed  for 
Class  I  but  there  will  be  a  difference  in  the  manner  of  determining  the 
principal  underlying  factors,  namely  the  quantity  and  quality  of  ore 
and  the  life  of  the  mine. 

In  Class  II  sole  reliance  cannot  be  placed  in  the  development  of 
ore  on  the  date  of  valuation,  but  concurrent  evidence  such  as  the 
habit  and  type  of  ore  bodies  in  the  mine  itself,  the  characteristics 
of  the  district  in  which  it  occurs,  the  rate  of  development  through 
exploration,  the  strength  of  mineralization,  the  stage  of  the  operating 
life  of  the  mine  and  any  other  satisfactory  evidence  may  be  used  to 
establish  a  reasonable  estimate  of  the  required  factors. 

On  the  basis  of  present  value  of  future  earnings,  we  have 
the  principles  of  valuation: 

1.  The  total  value  of  a  property  at  any  date  is  the  value 
of  the  future  earnings  of  such  property  discounted  to  that 
date. 

2.  The  value  of  the  mineral  in  the  ground  at  any  date  is 
the  total  value  of  the  property  as  above,  less  the  value  of  the 
present  and  prosp)ective  capital  expenditures  for  plant,  develop>- 
ment  and  equipment  necessary  to  recover  such  mineral  dis- 
counted to  the  same  date. 

To  obtain  this  value  the  following  factors  must  be  deter- 
mined. 

I.  Tonnage  available.  This  can  be  estimated  with  a  great 
degree  of  accuracy  for  regular  deposits  of  coal,   iron  ore, 


T 


230      COLUMBIA     INCOME     TAX     LECTURES 

disseminated  copper  and  the  like:  for  less  regular  deposits  the 
best  information  available  must  be  used. 

With  respect  to  reserves,  only  such  mineral  as  can  be 
mined  within  a  reasonable  time  should  be  included  as  available, 
and  that  all  in  excess  of  this  shall  be  classed  as  "reserves 
unavailable."  This  should  be  carried  as  a  separate  item  and 
under  no  circumstances  be  subject  to  depletion.  It  is  sug- 
gested that  a  proper  time  limit  for  available  mineral  shall 
be  such  that  its  present  value  on  an  annuity  basis  would  be 
ninety  per  cent,  of  the  present  value  of  an  infinite  amount, 
t.e.,  a  perpetual  annuity.  At  six  per  cent,  discount  rate  this 
time  limit  would  be  forty  years  life,  and  at  eight  per  cent., 
thirty  years,  which  may  be  properly  considered  as  maxima. 
Properties  with  shorter  lives  would  of  course  have  depletion 
percentages  calculated  on  the  ratio  of  the  present  value  for 
estimated  life  divided  by  years  of  life.  The  life  of  any  property 
would  be  properly  calculated  on  estimated  average  future 
output,  taking  into  account  probable  future  changes  as  well 
as  past  experience. 

2.  Life  of  property.  This  can  be  estimated  with  careful 
study  with  reasonable  accuracy,  and  even  considerable  errors 
in  total  life,  if  this  be  fairly  long,  have  but  small  influence  on 
the  present  value. 

3.  Capital  charges  for  development,  plant  and  equipment. 
The  value  of  existing  plant,  etc.,  is  readily  ascertainable,  and 
the  value  of  future  necessary  capital  expenditures  can  be 
reasonably  estimated. 

4.  Profit  from  operation.  This  is  the  undeterminable 
factor  and  can  only  be  estimated  to  the  best  judgment  of  the 
valuing  engineer. 

In  estimating  the  probable  profit  from  operation,  we  believe 
that  it  is  proper  to  consider  the  trend  of  conditions  prior  to 
19 1 3  and  such  profits  after  that  date  as  could  be  reasonably 
inferred  from  such  conditions.  It  is  not  proper  to  use  war  con- 
ditions as  applying  to  the  future,  as  it  is  most  improbable  that 
these  will  continue,  and  as  the  war  could  not  have  been  antid- 
pated  in  1913,  the  valuing  engineer  is  not  justified  in  using  war 
prices  as  a  basis  for  valuation. 


INCOME    FROM    NATURAL    RESOURCES         23I 

Calculation  of  Valuation.  Having  determined  the  above 
factors  the  valuation  is  determined  by  discounting  to  the 
desired  date  at  compound  interest : 

1.  The  total  net  profits  year  by  year  and 

2.  The  estimated  capital  expenditures  year  by  year,  to 
which  is  added  the  estimated  value  of  plant,  development  and 
equipment  at  the  basic  date. 

The  total  value  of  the  property  will  be  given  by  i.  Through 
I  and  2,  one  determines  the  value  of  the  mineral  in  the  ground, 
the  depletable  value.  The  depletion  charge  per  ton  will  be  the 
value  of  the  mineral  in  the  ground  as  above  divided  by  the 
available  tonnage  (not  including  reserves). 

Depletion.  This  amount  taken  on  all  available  tonnage 
estimated  will  return  the  value  of  the  property  on  the  exhaus- 
tion of  the  estimated  tonnage.  The  method  has  the  advantage 
of  a  known  and  fixed  tonnage  depletion,  but  the  grave  dis- 
advantage that  year  by  year  the  depletion  has  no  standard 
relation  to  earnings.  In  bad  years  or  cycles  the  earnings  may 
be  actually  less  than  the  depletion  allowance.  The  result 
of  this  method  is  that  the  depletion  allowance  adds  unduly 
to  the  cost  of  mineral  in  years  of  low  output  and  excessive  cost, 
and  is  negligible  in  years  of  high  output  and  resulting  low 
cost,  so  that  the  tcixes  paid  are  unduly  irregular  and  in  poor 
years  there  may  easily  be  no  remaining  earnings  for  taxation. 

Suggested  Method  for  Depletion.  It  is  suggested  that  in  lieu 
of  the  tonnage  depletion,  this  be  based  on  earnings,  following 
the  above  procedure  in  principle,  but  instead  of  figures  based 
on  estimated  earnings  the  actual  earnings  for  each  year  be 
used,  and  the  depletion  be  calculated  as  a  percentage  on  earn- 
ings based  on  the  ratio  of  the  present  value  of  an  annuity  of 
$1.00  for  the  estimated  life  of  the  property,  divided  by  the 
years  of  estimated  life.  This  method  gives  practically  the  same 
ultimate  result  as  the  tonnage  depletion,  except  that  it  sub- 
stitutes in  the  calculation  the  actual  for  the  estimated  earnings, 
and  varies  the  depletion  year  by  year  in  relation  to  earnings. 
It,  however,  returns  to  the  owner  the  actual  value  of  his  prop- 
erty at  the  basic  date,  based  on  the  value  of  its  earnings, 
instead  of  an  estimated  value.    It  results  for  the  Government 


232       COLUMBIA     INCOME     TAX     LECTURES 

in  taxes  in  all  years  where  there  are  any  earnings,  and  equal- 
izes the  tax  returns. 

If  it  is  objected  that  this  methcxl  might  result  in  excessive 
depletion  for  the  war  years,  it  could  be  modified  by  using 
instead  of  the  actual  earnings  for  these  years  the  average 
earnings  of  the  pre-war  years,  say  from  1910  to  1916  inclusive, 
or  the  objection  is  probably  removed  by  not  making  the  ruling 
retroactive,  as  the  earnings  of  the  natural  resources  industries 
have  returned  to  practically  normal. 

The  percentages  of  earnings  taken  for  depletion  for  a 
life  of  the  operation  from  one  year  to  the  limit  of  calculation 
at  six  per  cent,  and  eight  per  cent,  interest  rate  are  shown  in 
the  following  table: 


0}  Life 

Per  Cent.  Earnings 

Per  Cent.  Ec 

Six  Per  Cent. 

Eight  Per 

I 

94-34 

92.59 

2 

91.67 

89.16 

5 

89.10 

85.90 

4 

86.63 

82.80 

5 

84.25 

79.85 

6 

81.96 

77.09 

7 

79.75 

74.37 

8 

77.62 

71.83 

9 

75.57 

69.40 

10 

73.60 

67.10 

II 

71.69 

64.89 

12 

69.87 

62.80 

13 

68.09 

60.79 

14 

66.38 

58.88 

15 

64.75 

57.06 

16 

63.16 

55.32 

17 

61.63 

53-64 

18 

60.15 

52.06 

19 

58.72 

50.54 

20 

57.34 

49.09 

21 

56.01 

47.70 

22 

54-73 

46.36 

23 

53.49 

45-09 

24 

52.29 

43-87 

25 

51-13 

42.70 

26 

50.01 

41.57 

27 

48-93 

40.49 

28 

47-87 

39-47 

29 

46.86 

38.47 

INCOME    FROM    NATURAL    RESOURCES         233 

Years  of  Life  Per  Cent.  Earnings       Per  Cent.  Earnings 

Six  Per  Cent.  Eight  Per  Cent. 

30  45-88  37.52 

31  44.93 

32  44.12 

33  43.12 

34  42.26 

35  41.10 

36  40.61 

37  39.82 

38  39.05 

39  38.33 

40  37.61 

As  an  example,  assume  a  property  with  very  large  reserves 
estimated  to  produce  1,000,000  tons  per  year,  with  an  esti- 
mated average  profit  over  depletion  of  twenty-five  cents  per 
ton,  its  yearly  income  would  be  $250,000,  and  the  present 

value  as  follows: 

Discount  rate 6%  8% 

Life 40  years  30  years 

Tonnage  available  .    .    .  40,000,000  30,000,000 

Present  value  ^i.oo  an-  »  « 

nuity ^15.046  yii.258 

Present  value  available 

tonnage ?3»76i,500  ^2,814,500 

Depletion  per  ton   .    .    .  9.404c.  9.382c. 
Depletion  Per  Cent,  of 

average  earnings     .    .  15.046  11258 

=  37.61%    =  37.53% 

40  30 

Taking  the  same  property  with  varying  earnings,  averaging 
twenty-five  cents  per  ton,  assuming  regular  output: 

Year  Earnings      Depletion  at      Earnings      Depletion  at 

Per  Ton     Six  Per  Cent.     Per  Ton     Eight  Per  Cent. 
Cents  Interest  Cents  Interest 

40  40  15.04 

39  20  7.52 

38  10  3.76 

37  5  1-85 

36  10  3.76 

35  25  9.40 

34  40  15.04 

33  30  11.28 

32  50  18.50 

31  20  7.52 

30  30  11.28                 9                3*38 


234       COLUMBIA     INCOME     TAX     LECTURES 


Year 


29 

28 

27 
26 

25 
24 
23 
22 
21 
20 

19 

18 

17 
16 

15 

H 

13 
12 

II 

10 

9 

8 

7 
6 

5 

4 

3 
2 

I 


Total 
Average 


Earnings 

Per  Ton 

Cents 

5 

5 
2 

8 

20 
30 
50 
60 

70 

50 
20 

5 
5 
3 

7 

15 

40 

35 
30 

15 

7 
3 

5 

15 

45 
60 

40 

30 

1000 
25c. 


Depletion  at 

Six  Per  Cent. 

Interest 

1.85 

1.85 

0.75 
301 

752 
11.28 
18.50 
22.56 
15.04 
26.32 
18.50 

7.52 

1.85 

1.85 

113 

2.83 

5-51 
1504 

13.13 
11.28 

5.51 
2.83 

113 
1.85 

5.51 
16.89 

22.56 

15.04 
11.28 


Earnings       Depletion  at 
Per  Ton   Eight  Per  Cent. 
Cents  Interest 


374.81 
9-37C. 


3 
8 

20 

40 

50 
20 

30 
40 

30 
20 

15 
6 

4 
15 
25 
35 
45 
60 

25 

15 
10 

5 
10 

25 
30 
70 

55 
20 

10 

750 
25c. 


1.13 
3.00 

750 
1500 

18.75 

7.50 

11.25 

1500 

11.25 

7.50 

563 

2.25 

1.50 
5.62 

9.38 

13.12 

16.88 

22.50 

9.38 

5.63 

3.75 
1.88 

3.75 

9.38 

11.25 

26.25 

20.63 

7.50 

3.75 

281.29 
9.37c. 


The  above  is  based  on  1,000,000  tons  output  per  year  and 
an  average  of  twenty-five  cents  per  ton,  showing  an  agreement 
in  total  results,  despite  the  widely  varying  earnings,  and  shows 
the  soundness  and  fairness  of  the  simple  method  proposed. 
It  should  be  noted  that,  under  a  tonnage  depletion  in  eleven 
years  out  of  the  forty,  and  five  out  of  the  thirty,  no  taxes 
would  have  been  paid,  as  the  earnings  are  less  than  the  deple- 
tion. 

With  this  proposed  plan  the  division  of  interest  between 
lessor  and  lessee  would  be  absolutely  simple,  as  the  royalty 


INCOME    FROM     NATURAL    RESOURCES 


235 


and  profit  (over  royalty)  would  each  be  depleted  on  the  same 
percentage  fixed  on  the  estimated  life  of  the  roperty. 

It  must  be  clearly  understood  that  the  above  "Suggested 
Method  for  Depletion"  is  the  suggestion  of  the  Engineers 
Committee  of  the  National  Coal  Association,  and  has  not 
been  accepted  by  the  Treasury. 

Discount  Rate.  The  question  of  the  proper  discount  rate  to 
be  used  to  obtain  present  value  is  a  mooted  one;  and,  under 
various  conditions,  rates  from  ten  per  cent.,  or  even  more,  down 
to  four  per  cent.,  and  under,  have  been  used  by  competent 
authorities,  while  the  need  of  higher  percentages  is  recognized 
in  doubtful  cases,  as  in  mines  where  the  amount  of  mineral 
remaining  is  not  ascertainable.  Tn  the  case  of  mines  in  well 
known  territory  the  six  per  cent,  discount  rate  is  considered 
proper.  This  is  the  legal  rate  of  interest,  and  while  it  may  be 
contended  that  a  business  like  mining  should  yield  a  higher 
rate  of  profit,  the  experience  of  years  shows  that  the  average 
profit  in  most  mining  ventures  is  below  rather  than  above  this 
percentage. 

It  seems  that,  at  least  for  taxation  purposes,  the  six  per 
cent,  figure  should  be  used.  This  has  the  authority  of  a 
standard  legal  rate,  and  anything  else,  except  to  discount 
uncertainties,  must  be  a  mere  assumption. 

While  six  per  cent,  is  believed  to  be  proper  in  most  cases  it 
is  recognized  that  a  higher  discount  rate  may  be  justly  used 
where  the  extent  or  continuity  of  the  deposit  is  doubtful. 

Much  of  this  has  been  reorganized  in  the  amended  regula- 
tions of  Dec.  29,  1920,  in  which  this  article  reads  as  follows: 

Article  206.  "Determination  of  Fair  Market  Value  of  Mineral 
Property." 

(a)  Where  the  fair  market  value  of  the  property  at  a  specified  date 
in  lieu  of  the  cost  thereof  is  the  basis  for  depletion  and  depreciation 
deductions,  such  value  must  be  determined,  subject  to  approval  or 
revision  by  the  Commissioner,  by  the  owner  of  the  property  in  the  light 
of  the  conditions  and  circumstances  known  at  that  date,  regardless  of 
later  discoveries  or  developments  in  the  property  or  subsequent  im- 
provements in  methods  of  extraction  and  treatment  of  the  mineral 
product.  The  value  sought  should  be  that  established  assuming  a 
transfer  between  a  willing  seller  and  a  willing  buyer  as  of  that  particular 
date.   The  Commissioner  will  lend  due  weight  and  consideration  to  any 


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236      COLUMBIA     INCOME     TAX     LECTURES 

and  all  factors  and  evidence  having  a  bearing  on  the  market  value,  such 
as  cost,  actual  sales  and  transfers  of  similar  properties,  market  value  of 
stock  or  shares,  royalties  and  rentals,  value  fixed  by  the  owner  for  pur- 
pose of  the  capital  stock  tax,  valuation  for  local  or  state  taxation,  part- 
nership accountings,  records  of  litigation  in  which  the  value  of  the 
property  was  in  question,  the  amount  at  which  the  property  may  have 
been  inventoried  in  probate  court,  disinterested  appraisals  by  approved 
methods  such  as  the  present  value  method  and  other  factors. 

(b)  To  determine  the  fair  market  value  of  a  mineral  property  by  the 
present  value  method,  the  essential  factors  must  be  determined  for 
each  deposit  included  in  the  property.  The  factors  are  (i)  the  total 
quantity  of  mineral  in  terms  of  the  principal  or  customary  unit  (or 
units)  paid  for  in  the  product  marketed,  (2)  the  average  quality  or 
grade  of  the  mineral  reserves,  (3)  the  expected  percentage  of  extraction 
or  recovery  in  each  process  or  operation  necessary  for  the  preparation 
of  the  crude  mineral  for  market,  (4)  the  probable  operating  life  of  the 
deposit  in  years,  (5)  the  unit  operating  cost,  i.e.,  cost  of  production 
exclusive  of  depreciation  and  depletion,  (6)  expected  average  selling 
price  per  unit  during  the  operating  life,  and  (7)  the  rate  of  profit  com- 
mensurate with  the  risk  for  the  particular  deposit.  When  the  deposit 
has  been  sufficiently  developed  these  factors  may  be  determined  from 
past  operating  experience.  In  the  application  of  factors  derived  from 
past  experience  full  allowance  should  be  made  for  probable  future 
variations  in  the  rate  of  exhaustion,  quality  or  grade  of  the  mineral, 
percentage  of  recovery,  costs  of  production  and  selling  price  of  the 
product  marketed  during  the  expected  operating  life  of  the  mineral 
deposit. 

(c)  Mineral  deposits  for  which  these  factors  may  not  be  determined 
with  reasonable  accuracy  from  past  operating  experience  may,  with  the 
approval  of  the  Commissioner,  be  valued  in  a  similar  manner;  but  the 
factors  must  be  deduced  from  concurrent  evidence,  such  as  the  general 
type  of  the  deposit,  the  characteristics  of  the  district  in  which  it  occurs, 
the  habit  of  the  mineral  deposits  in  the  property  itself,  the  intensity  of 
mmeralization,  the  rate  at  which  additional  mineral  has  been  disclosed 
by  exploitation,  the  stage  of  the  operating  life  of  the  property,  and  other 
evidence  tending  to  establish  a  reasonable  estimate  of  the  required 
factors. 

(d)  Mineral  deposits  of  different  grades,  locations  and  probable  dates 
of  extraction  in  a  pineral  property  shall  be  valued  separately.  The 
mineral  content  of  a  deposit  should  be  determined  in  accordance  with 
Article  208  in  the  case  of  mines,  with  Article  209  in  the  case  of  oil  wells, 
and  with  Articles  2 11  and  212  in  the  case  of  gas  wells.  In  estimating  the 
average  grade  of  the  developed  and  prospective  mineral,  account  should 
be  taken  of  probable  increases  or  decreases  as  indicated  by  the  operating 
history.  The  rate  of  exhaustion  of  a  mineral  deposit  should  be  deter- 
mined with  due  regard  to  the  limitations  imposed  by  plant  capacity, 
by  the  character  of  the  deposit,  by  the  ability  to  market  the  mineral 
product,  by  labor  conditions,  and  by  the  operating  program  in  force  or 
definitely  adopted  at  the  basic  date  for  future  operations.  The  operat- 
ing life  of  a  mineral  deposit  is  that  number  of  years  necessary  for  the 
exhaustion  of  both  the  developed  and  prospective  mineral  content  at 


INCOME    FROM    NATURAL    RESOURCES         237 

the  rate  determined  as  above.  The  operating  cost  comprises  all  current 
expense  of  producing,  preparing  and  marketing  the  mineral  product 
sold,  exclusive  of  Federal  Income,  War  Profits  and  Excess  Profits 
Taxes,  allowable  capital  additions  as  defined  in  Article  222,  and  deduc- 
tions for  depreciation  and  depletion,  but  including  cost  of  repairs  and 
replacements  necessary  to  maintain  the  plant  and  equipment  at  its 
rated  capacity  and  efficiency.  This  cost  of  repairs  and  replacements  is 
not  to  be  confused  with  the  depreciation  deduction  by  which  the  cost 
or  value  of  plant  and  equipment  is  returned  to  the  taxpayer  free  from 
tax.  In  general  no  estimates  of  these  factors  will  be  approved  by  the 
Commissioner  which  are  not  supported  by  the  operating  experience  of 
the  property  or  which  are  derived  from  different  and  arbitrarily  selected 
periods. 

{e)  The  product  of  the  number  of  units  of  mineral  recoverable  in 
marketable  form  by  the  difference  between  the  selling  price  and  the 
operating  cost  per  unit  is  the  total  expected  operating  profit.  The  value 
of  each  mineral  deposit  is  then  the  total  expected  operating  profit  from 
that  deposit  reduced  to  a  present  value  as  of  the  basic  date  at  the  rate  of 
interest  commensurate  with  the  risk  for  the  operating  life,  and  further 
reduced  by  the  value  at  the  basic  date  of  the  depreciable  assets  and  of 
the  capital  additions,  if  any,  necessary  to  realize  the  profits. 

Article  207.  Once  the  value  of  a  property  is  fixed,  re-apprai- 
sals are  not  allowed,  though  a  revision  of  the  unit  values  is  re- 
quired if  changes  from  estimates  are  determined.  This 
appears  to  be  strictly  a  "ruling"  as  we  can  find  nothing  in  the 
law  requiring  such  a  drastic  interpretation. 

Article  208.  "Determination  of  Quantities."  Quantities 
are  required  to  be  estimated  as  of  March  i,  1913.  In  making 
such  an  estimate  any  engineer  would  make  his  estimate  up  to 
the  date  of  examination,  and  reduce  to  the  basic  date  by  adding 
the  units  produced  between  the  basic  date  and  the  date  of 
examination. 

While  perhaps  technically  no  information  not  available 
March  i,  1913,  is  supposed  to  be  used  in  such  estimates,  in  this 
case,  as  in  the  case  of  estimating  profits,  no  engineer  would,  or 
should  be  asked  to  stultify  himself  by  using  estimates  based  on 
what  he  may  try  to  imagine  he  would  have  thought  on  March 
I,  1913,  but  which  on  information  available  when  his  estimate 
was  actually  made  he  knows  to  be  incorrect. 

The  regulations  provide  that: 

The  estimate  of  the  recoverable  units  of  ores  or  minerals  for  the  pur- 
pose of  depletion  shall  include: 

a.  The  ores  and  minerals  "in  sight,"  "blocked  out,"  "developed"  or 


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238      COLUMBIA     INCOME     TAX     LECTURES 


b. 


"assured"  in  the  usual  or  conventional  meaning  of  these  terms  in 
respect  to  the  type  of  deposit,  and  may  also  include 
"Prospective,"  or  "probable"  ores  and  minerals  (in  the  same  sense), 
that  is,  ores  and  minerals  that  are  believed  to  exist  on  the  basis 
of  good  evidence,  although  not  actually  known  to  occur  on  the 
basis  of  existing  development;  but  "probable"  or  "prospective" 
ores  and  minerals  may  be  computed  for  purposes  of  depletion  only 
as  extensions  of  known  deposits  into  undeveloped  ground,  as  to 
quantity  and  richness  only  on  geological  evidence  of  high  degree  of 
probability. 

Article  209.  "Determination  of  Quantity  of  Oil  in  Ground." 
An  estimate  is  required  of  the  probable  recoverable  oil  as  of 
March  i,  1913,  or  at  the  date  of  purchase,  or  within  thirty 
days  after  discovery.  But  the  estimate,  if  subsequently 
proved  clearly  erroneous,  may  be  revised  with  the  approval 
of  the  Commissioner. 

This  is  undoubtedly  due  to  the  supposedly  less  accurate 
estimates  of  oil  as  compared  with  minerals.  As  a  matter  of  fact 
in  many  cases  one  is  no  more  accurate  than  the  other,  and  it 
would  be  only  just  to  extend  this  section  to  mines. 

Article  210.  "Computation  of  Deduction  for  Depletion  of 
Mineral  Deposits." 

(a)  Depletion  attaches  to  the  annual  production  "according  to  the 
peculiar  conditions  of  each  case"  and  when  the  depletion  actually  sus- 
tained, whether  legally  allowable  or  not,  from  the  basic  date,  equals  the 
cost  or  value  on  the  basic  date  plus  subsequent  allowable  capital  addi- 
tions, no  further  deduction  for  depletion  will  be  allowed  except  in 
consequence  of  added  value  arising  through  discovery  or  purchase  (See 
Articles  202,  203,  204,  and  222). 

(b)  When  the  value  of  the  property  at  the  basic  date  has  been  deter- 
mined, depletion  for  the  taxable  year  shall  be  determined  by  dividing 
the  value  remaining  for  depletion  by  the  number  of  units  of  mineral  to 
which  this  value  is  applicable  and  by  multiplying  the  unit  value  for 
depletion,  so  determined,  by  the  number  of  units  sold  within  the  taxa- 
ble year.  In  the  selection  of  a  unit  for  depletion  preference  shall  be 
given  to  the  principal  or  customary  unit  or  units  paid  for  in  the  product 
sold. 

Article  21 1-212.    "Depletion  of  Gas  Wells."    Rather  specific 

directions  for  computing  depletion  for  gas  wells  are  given, 

including  detailed  directions  for  determining  pressures;  these 

are  to  be  applied  to  the  formula : 

The  quotient  of  the  capital  account  recoverable  through  depletion 
allowances  to  the  end  of  the  taxable  year,  divided  by  the  sum  of  the 


INCOME    FROM    NATURAL    RESOURCES        239 

pressures  at  the  beginning  of  the  year  less  the  sum  of  the  pressures  at 
the  time  of  expected  abandonment  (which  quotient  is  the  unit  cost), 
multiplied  by  the  sum  of  the  pressures  at  the  beginning  of  the  taxable 
year  plus  the  sum  of  the  pressures  of  new  wells  less  the  sum  of  the 
pressures  at  the  end  of  the  tax  year,  equals  the  depletion  allowance. 

Article  213.  Where  figures  are  unavailable  tentative  esti- 
mates may  be  made  to  be  replaced  by  later  estimates. 

Articles  214.  "Computation  of  Depletion  Allowance  for 
Combined  Holdings  of  Oil  and  Gas  Wells."  This  section  allows 
a  combined  report  and  general  depletion  of  all  holdings. 

Article  215.  "Depletion  of  Mines  Based  on  Advance  Roy- 
alties." When  under  a  lease  a  minimum  royalty,  permitting 
the  removal  of  a  corresponding  number  of  units  of  mineral,  is 
paid,  the  lessor  may  claim  depletion  for  the  units  thus  paid  for 
even  if  not  mined,  but  if  these  are  mined  later  no  further  deple- 
tion is  allowed ;  but  in  the  event  that  the  property  is  returned 
or  re-possessed,  an  amount  equal  to  the  aggregate  deductions 
for  depletion  for  mineral  still  in  the  ground  will  be  deemed 
income  to  lessor  and  returned  as  such  for  the  year  the  property 
is  repossessed. 

In  our  opinion  this  also  applies  to  depletion  for  the  lessee. 

Article  216.  Book  accounts  are  required,  in  which  the 
value  shall  be  entered  and  depletion  charged.  The  Court, 
in  Forty  Fort  Coal  Co.  v.  Kirkendall,  Collector  (223  Fed.  704), 
decided  that  depletion  might  be  properly  taken  regardless  of 
book  accounts. 

Articles  217,  218.  Where  depletion  is  claimed,  and  in  fact 
where  any  deductions  in  the  case  of  natural  resources  are 
claimed,  the  taxpayer  is  required  to  fill  out  a  statement,  in 
the  form  of  a  rather  complicated  questionnaire.  These  ques- 
tionnaires have  been  drawn  to  furnish  all  possible  information 
which  may  be  of  use  in  determining  values,  depletion,  deprecia- 
tion, etc.  They  are  properly  made  voluminous,  and  call  for 
very  much  data  not  in  the  possession  of  most  taxpayers.  These 
should  be  filled  out  as  far  as  practicable.  As  a  general  rule  only 
data  necessary  in  determining  the  claims  made  by  a  taxpayer 
are  required.  Ancient  history  and  data  not  affecting  the  tax- 
payers claim  are  not  needed  and  the  blanks  for  this  need  not 
be  filled.     For  instance,  the  questionnaire  requires,  "Cost  of 


P 


I  H. 

I 


I 


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240      COLUMBIA     INCOME     TAX     LECTURES 

property."  In  the  case  of  an  estate  the  accepted  answer  was 
"inherited" — "unknown."  While  the  questionnaires  apparently 
require  a  brief  of  title  of  all  property  the  Treasury  seems  to  be 
entirely  satisfied  with  the  most  recent  transfers. 

In  general  the  Treasury  is  most  reasonable  and  does  not 
require  nor  expect  special  research  to  make  out  their  question- 
naires. 

Article  219.    "Discovery  of  Mines." 

(a)  To  entitle  a  taxpayer  to  a  valuation  of  his  property  for  the  pur- 
pose of  depletion  allowances,  by  reason  of  the  discovery  of  a  mine  on  or 
after  March  i,  191 3,  the  discovery  must  be  made  by  the  taxpayer  after 
that  date  and  must  result  in  the  fair  market  value  of  the  property  be- 
coming disproportionate  to  the  cost.  The  fair  market  value  of  the 
property  will  be  deemed  to  have  become  disproportionate  to  the  cost 
when  the  newly  discovered  mine  contains  mineral  in  such  quantity  and 
of  such  quality  as  to  afford  a  reasonable  expectation  of  return  to  the 
taxpayer  of  an  amount  materially  in  excess  of  the  capital  expended  in 
making  such  discovery  plus  the  cost  of  future  development,  equipment, 
and  exploration. 

(b)  For  the  purpose  of  these  sections  of  the  Act  a  mine  may  be  said 
to  be  discovered  when  (i)  there  is  found  a  natural  deposit  of  mineral,  or 
(2)  there  is  disclosed  by  drilling  or  exploration,  conducted  above  or 
below  ground,  a  mineral  deposit  not  previously  known  to  exist  and  so 
improbable  that  it  had  not  been,  and  could  not  have  been,  included  in 
any  previous  valuation  for  the  purpose  of  depletion,  and  which  in  either 
case  exists  in  quantity  and  grade  sufficient  to  justify  commercial  ex- 
ploitation. The  discovery  must  add  a  new  mine  to  those  previously 
known  to  exist  and  cannot  be  made  within  a  proven  tract  or  lease  as 
defined  in  paragraph  (f)  infra. 

(c)  In  determining  whether  a  discovery  entitling  the  taxpayer  to  a 
valuation  has  been  made,  the  Commissioner  will  take  into  account  the 
peculiar  conditions  of  each  case;  but  no  discovery,  for  the  purposes  of 
valuation,  can  be  allowed,  as  to  ores  or  minerals,  such  as  extension  of 
known  ore  bodies,  that  have  been  or  should  have  been  included  in 
"probable"  or  "prospective"  ore  or  mineral,  or  in  any  other  way  com- 
prehended in  a  prior  valuation,  nor  as  of  a  date  subsequent  to  that  when, 
in  fact,  discovery  was  evident,  when  delay  by  the  taxpayer  in  making 
claim  therefor  has  resulted  or  will  result  in  excessive  allowances  for 
depletion. 

(d)  The  value  of  the  property  claimed  as  a  result  of  a  discovery  must 
be  the  fair  market  value,  as  defined  in  Article  206,  based  on  what  is 
evident  within  thirty  days  after  the  commercially  valuable  character 
and  extent  of  the  discovered  deposits  of  ore  or  mineral  have  with 
reasonable  certainty  been  established,  determined  or  proved. 

(«)  After  a  bona  fide  discovery  the  taxpayer  shall  adjust  his  capital 
and  depletion  accounts  in  accordance  with  Articles  206,  208,  and  210, 
and  shall  submit  such  evidence  as  to  establish  his  right  to  a  revaluation, 


INCOME    FROM    NATURAL    RESOURCES         24I 

covering  the  conditions  and  circumstances  of  the  discovery  and  the 
size,  character  and  location  of  the  discovered  deposit  of  mineral,  the 
value  of  the  property  at  the  prior  basic  date,  the  cost  of  discovery,  and 
its  development,  equipment  and  exploitation,  its  value  and  the  particu- 
lar method  used  in  the  determination. 

(J)  In  the  case  of  a  mine,  a  "proven  tract  or  lease"  includes,  but  is  not 
necessarily  limited  to,  the  mineral  deposits  known  to  exist  in  any 
known  mine  at  the  date  as  of  which  such  mine  was  valued  for  purposes 
of  depletion,  and  all  extensions  thereof,  including  "probable"  and  "pro- 
spective" ores  considered  as  a  factor  in  the  determination  of  their  value 
or  cost. 

The  A.  I.  M.  E.  Committee  suggested  in  addition: 
(g)  The  proving  by  the  taxpayer  of  the  commercial  value  of  a  mineral 
or  ore  deposit  by  the  development,  refinement  or  perfection  of  known 
methods  or  processes  of  mining  or  metallurgy  or  both  or  by  the  dis- 
covery and  application  of  new  methods  of  mining  and  metallurgy  at  a 
cost  materially  less  than  the  commercial  value  of  the  deposit  thus 
proven  or  created.  The  estimation  of  the  value  of  the  deposit  must  be 
made  as  of  a  date  not  later  than  thirty  days  after  the  commercial  value 
of  the  deposit  has  thus  been  proven. 

Further  ore  discovered  either  by  further  development  or  exploration, 
whether  this  ore  be  an  extension  of  a  previously  known  ore  body,  or  a 
new  ore  body  or  by  improved  processes  of  treatment,  and  not  included 
within  the  previously  estimated  value  or  estimated  life  of  the  mine, 
may  be  valued  for  depletion  purposes  following  such  discovery  or  dis- 
coveries. 

The  law  is  perfectly  clear  in  its  thirty  days,  but  all  engineers 
know  that  this  limit  is  much  too  short.  Six  months  or  a  year 
would  be  better. 

As  a  matter  of  fact,  however,  the  discovery  is  not  really  con- 
summated until  a  reasonable  amount  of  profitable  mineral  has 
been  proved,  so  that  the  actual  date  of  discovery  is  not  the 
date  of  finding  an  outcrop,  or  putting  a  drill  hole  through  ore, 
or  even  exposing  valuable  mineral  in  underground  workings. 
The  regulation  states  cleariy  that  the  discovery  must  be  of  a 
commercially  valuable  deposit.  Hence  the  date  of  discovery  will 
be  very  hard  to  determine,  and  in  the  final  analysis  will  rest 
largely  in  the  discretion  of  the  Treasury. 

Articles  220-221  (Revised.)  The  law  provides  that  taxpayers 
who  discover  oil  and  gas  wells  on  or  after  March  i,  1913, 
may,  under  the  circumstances  therein  prescribed,  determine 
the  fair  market  value  of  such  property  at  the  date  of  discovery 
or  within  thirty  days  thereafter  for  the  purpose  of  ascertain- 
ing allowable  deductions  for  depletion.    Before  such  valuation 


!,  t 


242       COLUMBIA     INCOME     TAX     LECTURES 

may  be  made  the  statute  requires  that  two  conditions  prece- 
dent be  satisfied: 

1.  That  the  fair  market  value  of  such  property  (oil  and  gas 
wells)  on  the  date  of  discovery  or  within  thirty  days 
thereafter  became  materially  disproportionate  to  the 
cost,  by  virtue  of  the  discovery,  and 

2.  That  such  oil  and  gas  wells  were  not  acquired  as  the  result 
of  purchase  of  a  proven  tract  or  lease. 

The  regulations  provide  that  a  discovery  is  made  when 
there  is  either  a  natural  exposure  or  a  drilling  disclosing  oil  or 
gas  in  sufficient  quantities  to  at  least  afford  a  reasonable 
expectation  of  returning  the  capital  invested  in  the  well. 

A  proven  tract  is  considered  to  be  a  square  of  i6o  acres, 
regardless  of  private  boundaries,  with  a  well  producing  oil  or 
g£is  in  commercial  quantities  as  its  center,  the  lines  of  the 
square  parallel  to  established  section  lines,  or  lacking  these 
the  sides  run,  north,  south,  east  and  west.  But  an  area 
immediately  surrounded  by  proven  areas  and  with  favorable 
geologic  structure  is  to  be  regarded  as  proven. 

The  property  to  be  revalued  is  the  "well,"  comprising  the 
actual  drill  hole,  the  surface  necessary  for  operation,  and  the 
gas  or  oil  content  of  the  zone  discovered  to  the  limit  of  the 
property,  but  not  exceeding  the  i6o  acre  square. 

To  revalue  after  March  i,  1913,  a  discovery  must  be  made 
after  that  date  which  results  in  the  fair  market  value  of  the 
property  being  materially  in  excess  of  its  cost,  or  value  as  of 
March  i,  1913,  plus  the  cost  of  exploration  and  development 
work  to  the  time  of  discovery. 

Full  proof  of  discovery  is  required,  details  of  drilling,  and  of 
out-put,  copy  of  records  showing  cost  of  property,  and  a  state- 
ment of  method  of  valuation — really  such  proof  as  any  court 
or  business  man  would  properly  demand. 

Article  222  (Revised.)  "Allowable  Capital  Additions  in  Case 

of  Mines.** 

(o)  All  expenditures  for  development,  rent  and  royalty  in  excess  of 
receipts  from  minerals  sold,  shall  be  charged  to  capital  account  recov- 
erable through  depletion,  while  the  mine  is  in  the  development  stage. 
Thereafter  any  development  which  adds  value  to  the  mineral  deposit 
beyond  the  current  year  shall  be  carried  as  a  deferred  charge  and 


INCOME    FROM    NATURAL    RESOURCES         243 

apportioned  and  deducted  as  operating  expense  in  the  years  to  which  it 

is  applicable.  .  ,    „  .       1.        j  ^ 

(b)  All  expenditures  for  plant  and  equipment  shall  be  charged  to 
capital  account  recoverable  through  depreciation,  while  the  mine  is  in 
the  development  state.  Thereafter  the  cost  of  major  items  of  plant  and 
equipment  shall  be  capitalized  but  the  cost  of  minor  items  of  equipment 
and  plant,  necessary  to  maintain  the  normal  output,  and  the  cost  of 
replacement  may  be  charged  to  current  expense  of  operation. 

It  is  somewhat  difficult  properly  to  draw  the  line  between 
capital  charges  and  operating  costs  as  indicated  above.  The 
clause  "necessary  to  maintain  a  normal  output"  indicates  that 
the  line  may  be  drawn  about  as  suggested  below. 

Capital    Charges.     There    should    be    charged    to    capital 

account : 

a.  The  value  of  the  mineral  in  the  ground ; 

b.  The  value  of  the  development; 

c.  The  value  of  mechanical  equipment  inside  and  outside 

and 

d.  The  value  of  plant,  buildings,  dwellings,  water-works, 
sewerage,  roads,  railroads,  plant  facilities  and  the  like. 
All  to  attain  but  not  to  maintain  output. 

Operating  Charges.  There  should  be  charged  to  operation 
all  costs  of  production,  all  development,  plant  and  equipment 
necessary  to  maintain  output.  All  overhead  expenses  neces- 
sary in  carrying  on  the  business,  all  local  taxes,  depletion 
and  depreciation. 

Development.  The  cost  of  the  development  of  a  property 
to  its  intended  output  is  properly  chargeable  to  capital.  All 
further  development  to  maintain  output  is  properly  operating 
expense.  A  mine  may  be  considered  developed  when  there  are 
sufficient  working  places  to  produce  the  designed  output,  and 
sufficient  entry  work  in  progress  to  replace  exhausted  areas 
and  maintain  output.  Sufficient  advance  development  should 
be  maintained  to  assure  beyond  question  the  maintenance  of 
output  under  unfavorable  conditions. 

Plant  and  Equipment.  All  plant  and  equipment  necessary 
to  bring  the  property  to  capacity  is  properiy  a  capital  charge. 
All  additions,  renewals  and  extensions  necessary  to  maintain 
output  should  be  charged  to  operation. 


'ill-. 


244      COLUMBIA     INCOME     TAX     LECTURES 

Deductions  from  Income.  Interest,  U.  S.  income  and  excess 
profits  taxes,  dividends,  additions  to  surplus,  capital  expendi- 
tures made  from  income,  and  charitable  contributions  by 
corporations  are  under  the  present  laws  not  chargeable  to 
operating  expenses,  but  are  included  in  taxable  income. 

In  this  connection  losses  must  be  considered  [Art.  214  (a) 
(4)  (5)  (6)  and  (8)  ].  These  include  the  voluntary  removal  of 
buildings  or  scrapping  of  equipment,  etc.,  and  losses  by  ob- 
solescence. 

In  some  cases  heavy  claims  for  depreciation  have  been  made 
in  error  and  refused,  when  the  actual  costs  were  losses  due  to 
removal  of  buildings,  and  scrapping  of  machinery,  which  if 
claimed  would  have  been  allowed. 

Art.  223.  "Charges  to  Capital  and  to  Expense  in  the  Case  of 
Oil  and  Gas  Wells."  Incidental  expenses,  and  the  cost  of 
drilling  unproductive  wells  may,  at  the  option  of  the  taxpayer, 
be  deducted  as  operating  expense,  or  charged  to  capital  and  be 
subject  to  depletion.  The  election  once  made  cannot  be  changed. 

Art.  224.  "Depletion  of  Mine  Improvements."  At  the 
option  of  the  taxpayer  depletion  may  be  made  to  include  plant 
and  equipment  charged  to  capital,  at  a  rate  determined  by  the 
rate  of  exhaustion  of  the  mineral,  or  a  depletion  account  for 
mineral  and  a  depreciation  account  for  plant  and  equipment 
may  be  used.  In  general  the  latter  is  better  accounting  and 
more  satisfactory  in  application. 

The  depreciation  may  be  based  on  either  physical  life,  "the 
estimated  time  such  plant,  or  unit,  when  given  proper  care 
and  repair,  can  be  continued  in  use  despite  physical  deterioia- 
tion,  decay,  wear  and  tear,"  or  economic  life,  "the  estimated 
time  during  which  the  plant  or  unit  may  be  utilized  effectively 
and  economically  for  its  intended  purpose,  and  may  be  limited 
by  the  life  of  the  property  .  .  .  but  can  never  exceed  the 
physical  life." 

Art.  225,  226.  "Depreciation  of  Improvements  in  Oil  and 
Gas  Wells."  Depreciation  on  capital  charges  for  equipmeny;o 
reduce  these  to  scrap  values  at  the  termination  of  the  esti- 
mated life  of  the  property  is  allowed,  even  though  such  life  be 
shorter  than  the  probable  normal  life  of  such  equipment. 


INCOME    FROM    NATURAL    RESOURCES        245 

Returns  prior  to  1916  need  not  be  re-opened,  unless  the 
deductions  are  decided  to  be  unreasonable. 

In  general  depletion  and  depreciation  are  intended  to 
return  the  value  of  the  property,  less  any  scrap  value  or  re- 
mainder value  at  the  termination  of  the  life  of  the  property, 
and  both  may  be  figured  on  the  probable  life  of  the  property 
even  though  a  short  life  may  materially  increase  the  allowances. 

Timber.  The  regulations  in  regard  to  depletion  of  timber 
properties  follow  in  general  the  lines  of  those  for  mines  and  oil 

and  gas. 

Art.  227,  228.  "Depletion  and  capital  recoverable"  from 
depletion  are  similar  to  the  corresponding  regulations  for  mines. 

Art.  229.  "Computation  of  Allowance  for  Depletion."  This 
is  based  on  the  feet  cut  during  the  year  at  the  unit  cost  of 
March  i,  1913,  or  the  date  of  acquisition  if  later. 

This  differs  from  other  depletion  rules  in  the  use  of  unit 
value  rather  than  the  total  value  of  the  property.  No  revalua- 
tion of  stumpage  is  allowed  (Art.  230),  but  the  unit  value  of 
stumpage  may  be  changed  if  it  is  found  inadequate  or  excessive 
to  return  the  fair  market  value  of  the  timber  as  of  March  I, 

Art.  231.  "Charges  to  Capital  and  to  Expense  in  the  Case 
of  Timber :" 

In  the  case  of  timber  operations  all  expenditures  for  plant,  equip- 
ment, development,  rent  and  royalty  prior  to  production,  and  thereafter 
all  major  items  of  plant  and  equipment,  shall  be  charged  to  capit^ 
account  for  purposes  of  depreciation.  After  a  timber  operation  and 
plant  has  been  developed  and  equipped  to  its  normal  and  regular  output 
capacity,  the  cost  of  additional  minor  items  of  equipment  and  the  cost 
of  replacement  of  minor  items  of  worn-out  and  discarded  plant  and 
equipment  may  be  charged  to  current  expenses  of  operation. 

Art.  232.  The  improvements  charged  to  capital  may  be 
included  in  the  stumpage  depletion  or  depreciated  separately. 

Art.  233.  Complete  statements  giving  full  data  are  re- 
quired of  property  owners  claiming  depreciation  or  depletion. 

Art.  234.  The  fair  market  value  of  a  tract  of  timber  as 
between  a  willing  seller  and  a  willing  buyer  as  of  March  i,  1913, 
must  be  based  on  the  property  as  it  existed  at  that  date,  regard- 
less of  subsequent  changes. 


1  ,-, 


4 


■I 

•r 
X 


246       COLUMBIA     INCOME     TAX     LECTURES 

Art.  235.  The  quantity  of  timber  as  of  March  I,  1913, 
or  on  date  of  acquisition,  must  be  estimated  in  detail,  in 
accordance  with  the  practice  of  the  basic  date:  adjustments 
of  rate  but  not  of  total  value  may  be  made  if  later  evidence 
shows  the  original  estimate  to  have  been  incorrect. 

Art.  236,  237.  Separate  blocks  of  timber  to  be  kept  in 
separate  accounts,  and  book  accounts  required  if  depletion 
or  depreciation  is  claimed. 

Conclusion.  The  foregoing  review  of  the  laws  and  regula- 
tions is  necessarily  incomplete,  but  it  is  hoped  full  enough  to 
give  a  reasonable  outline  of  this  very  technical  branch  of 

income  taxation. 

The  Commissioner  is  honestly  endeavoring  to  administer 
the  law  with  justice  and  with  common  sense,  but  the  subject 
is  difficult,  involving  technical  knowledge  and  experience, 
hardly  to  be  expected  of  the  rank  and  file  of  Treasury  em- 
ployees, and  not  attainable  at  the  salaries  paid  even  to  the 
heads  of  departments,  except  at  a  great  personal  sacrifice,  and 
the  engineers  who  have  handled  the  difficult  work  of  the 
Natural  Resources  Subdivision  have  done  so  at  such  great 
personal  sacrifice  as  to  put  the  business  community  very 

deeply  in  their  debt. 

Accounting.  Many  of  the  industries,  as  the  bituminous 
and  anthracite  operators,  the  Lake  Superior  Iron  Region, 
and  others,  have  appointed  competent  committees  and  have 
adopted  uniform  standard  accounting  systems,  which  gener- 
ally have  received  the  approval  of  the  Treasury,  and  the 
general  use  of  which  greatly  simplifies  the  work  of  properly 
reporting  earnings,  and  further  permits  actual  comparisons 
of  costs,  which  was  impossible  with  the  widely  varying  ac- 
counting or  rather  lack  of  accounting  existing  prior  to  the  im- 
position of  the  income  and  excess  profits  taxes. 

The  law  as  it  stands  involves  the  use  of  much  data  not 
generally  available,  and  in  many  instances  requires  technical 
services  of  a  high  grade,  to  ascertain  the  figures  and  present 
them  properly.  It  would  seem  that  practically  the  same  re- 
sults could  be  obtained  from  a  much  simplified  law. 

The  following  lines  of  changes  might  well  be  considered : 


INCOME    FROM    NATURAL    RESOURCES         247 

First.— Invested  Capital.      Article  838  should  be  amended 
by  adding: 

But  in  the  case  of  mines  and  mineral  deposits,  where  legitimate 
expenditures  have  been  made  for  the  purpose  of  developmg  known  ore 
bodies,  or  mineral  deposits,  and  ascertainable  values  have  been  added 
to  the  property,  or  where,  as  a  result  of  development  undertaken,  ex- 
ploration conducted,  or  the  adaptation  of  improved  processes,  deposits 
or  portions  thereof  unknown  or  without  value  at  the  date  when  the  mm- 
ine  property  was  acquired,  or  which  were  not  then  susceptible  of  most 
efficient  beneficiation,  have  been  developed  and  given  a  value  or  an 
additional  value  which  can  be  ascertained  with  reasonable  accuracy, 
such  value  or  additional  value  shall  be  regarded  as  surplus  and  shall  be 
included  in  invested  capital;  such  earned  value  not  being  value  appre- 
ciation" within  the  meaning  of  the  last  paragraph  of  Article  844. 

Second.—  Depletion.  As  the  fair  value  of  a  property  at  any 
date  is  the  present  value  of  the  future  earnings  discounted  to 
that  date,  depletion  could  logically  be  taken  as  a  percentage 
of  earnings  for  each  year,  such  percentage  being  the  present 
value  of  an  annuity  of  $1.00  per  year  for  the  estimated  life  of 
the  property,  divided  by  the  number  of  years  estimated  life. 
This  would  return  the  actual  value  of  the  property  as  of  the 
basic  date,  as  the  actual  earnings  year  by  year,  instead  of  the 
estimated  earnings,  would  be  used  in  the  calculations  of  value. 
The  maximum  life  should  be  limited  as  hereinbefore  sug- 
gested, and  interest  rates  fixed  for  the  different  industries. 

This  leaves  only  the  probable  life  as  a  factor  to  be  deter- 
mined and  errors  in  that  would  not  be  serious,  as  when  one 
hundred  per  cent,  depletion  had  been  paid  the  deduction  for 
depletion  would  cease. 

Third.— Value.  If  the  foregoing  is  not  acceptable  the  values 
of  properties  for  depletion  purposes  should  be  redetermined  at 
regular  intervals.  It  is  only  just  to  put  properties  remaining 
in  one  control  on  a  parity  with  those  with  changing  control, 
which  benefit  in  depletion  by  having  paid  the  going  value  at 

the  time  of  their  purchase. 

Fourth.-  Depreciation .  The  present  depreciation  accounting 
should  be  simplified.  This  might  be  accomplished  by  deter- 
mining for  each  class  of  equipment  a  standard  life,  then  for 
each  subdivision  of  industry  the  average  or  normal  per- 
centage of  each  class  used,  thus  calculating,  as  a  weighted 


!i 


Ij 


11 


I 


248       COLUMBIA     INCOME     TAX     LECTURES 

average,  the  general  life  of  all  equipment  in  the  form  of  a 
percentage,  this  to  be  used  as  a  base,  subject  to  correction 
for  short-lived  properties. 

Fifth. — Capital  Charges.  A  more  definite  line  should  be 
drawn  between  operating  costs  and  capital  charges.  This  could 
be  done  by  changing  the  present  regulation  (Article  222)  to 
read: 

Charges  to  Capital  and  to  Expense  in  the  Case  of  a  Mine.  In  the  case 
of  mining  operations  all  expenditures  for  plant  equipment,  development, 
rent  and  royalty,  and  all  carrying  charges  prior  to  production,  and 
thereafter  all  major  items  of  plant  and  equipment  to  increase  but  not  to 
maintain  production,  shall  be  charged  to  capital  account  for  the  purpose 
of  depletion  and  depreciation.  After  a  mine  has  been  developed  and 
equipped  to  its  normal  and  regular  output  capacity,  however,  the  cost 
of  additional  development  and  items  of  equipment  and  plant  including 
mules,  motors,  mine  cars,  trackage,  cables,  trolley  wire,  fans,  small 
tools,  etc.,  necessary  to  maintain  the  normal  output  because  of  in- 
creased length  of  haul  or  depth  of  working  consequent  on  the  extraction 
of  mineral,  and  the  cost  of  replacements  of  these  and  similar  items  of 
worn-out  and  discarded  plant  and  equipment,  may  be  charged  to  cur- 
rent expense  of  operations,  unless  the  taxpayer  elects  to  write  off  such 
expenditures  through  charges  for  depreciation. 

This  is  only  just,  as  such  increase  in  equipment  to  maintain 
but  not  to  increase  output  does  not  increase  the  value  of  the 
property,  but  only  increases  expense,  and  the  capital  account 
should  not  be  burdened  with  such  charges. 

Sixth. — Discovery. — A  broadening  and  clarifying  of  the  defi- 
nitions and  regulations  regarding  "discovery."  This  might  well 
be  accomplished  by  accepting  the  suggestion  of  the  A.  I.  M.  E. 
Committee: 

1.  That  Article  219,  of  Regulations  45,  as  revised,  be  amended  by 
inserting  after  the  words  "proving  and  development"  at  the  end  of  the 
first  paragraph  thereof,  a  new  sub-division  to  be  known  as  sub-division 
(c),  to  read  as  follows; 

(c)  the  proving  by  the  taxpayer  of  the  commercial  value  of  a 
mineral  or  ore  deposit  by  the  development,  refinement  or  perfection 
of  known  methods  or  processes  of  mining  or  metallurgy,  or  both,  or 
by  the  discovery  and  application  of  new  methods  of  mining  or 
metallurgy  at  a  cost  materially  less  than  the  commercial  value  of  the 
deposit  thus  proven  or  created.  The  estimation  of  the  value  of  the 
deposit  must  be  made  as  of  a  date  not  later  than  thirty  days  after  the 
commercial  value  of  the  deposit  has  thus  been  proven. 

2.  Further  ore  discovered  either  by  further  development  or  explora- 
tion whether  this  ore  be  an  extension  of  a  previously  known  ore  body  or 


INCOME    FROM    NATURAL    RESOURCES        249 

a  new  ore  body  or  by  improved  processes  of  treatment,  and  not  included 
within  the  previously  estimated  value  or  estimated  life  of  the  mine 
may  be  valued  for  depletion  purposes  following  such  discovery  or  dis- 
coveries. 

In  general  such  modifications  of  the  law  are  desirable  as 
tend  to  its  simplification,  and  reduce  the  labor  of  preparing 
and  of  checking  up  returns,  and  which  reduce  to  a  minimum 
the  possibility  of  misunderstanding  or  dispute  as  to  what  is 
to  be  returned  as  net  income. 


( '■■ 


I 


m 


RELIEF  PROVISIONS  AND  TREASURY 
PROCEDURE  ON  APPEALS 


BY 


P.  S.  Talbert 


Broadly  speaking,  any  of  the  deductions  or  credits  which 
have  the  effect  of  reducing  taxes  might  be  considered  to  be 
relief  provisions  in  these  days  of  high  taxes,  but  I  shall  confine 
my  application  of  the  term  to  those  provisions  not  contained 
in  previous  income  tax  laws  and  inserted  in  the  Revenue  Act 
of  1918  for  the  undoubted  purpose  of  affording  special  relief, 
in  view  of  the  high  rates  of  war  taxes,  against  hardships  definite 
or  indefinite,  likely  to  arise  either  from  anticipated  business 
conditions  or  operation  of  the  law  in  certain  cases. 

In  passing,  I  might  call  attention  here  to  the  fact  that  much 
of  the  intricacy  of  the  law  and  most  of  the  complexity  of  the 
forms,  about  which  there  has  been  loud  complaint,  are  due  to 
the  numerous  relief  provisions  and  the  necessity  for  providing 
on  the  form-blanks  opportunity  for  every  taxpayer  to  take 
advantage  of  any  of  them  to  which  he  is  entitled. 

These  relief  provisions  fall  naturally  into  two  classes,  those 
authorizing  specific  deductions  or  credits  under  certain  condi- 
tions and  those  of  an  administrative  nature. 

In  the  first  class  are  the  deductions  for  amortization  of  cost 
of  war  plant  or  facilities;  for  inventory  losses  which  it  was 
anticipated  would  occur  in  19 19;  ^or  net  losses  sustained  in 
1919;  for  revaluation  for  depletion  purposes  of  oil  and  gas 
,  wells  and  mines;  for  limitation  of  the  tax  on  profits  made 
through  the  sale  of  mines  and  oil  and  gas  wells  by  the  dis- 
coverer; credits  for  foreign  income  and  profits  taxes  paid 
against  similar  taxes  due  the  United  States,  and  exemption  of 
corporations  engaged  in  the  mining  of  gold  from  the  profits 
taxes  on  income  from  that  source. 


RELIEF    PROVISIONS    AND    APPEALS  25I 

Falling  in  the  second  class  are  the  provisions  authorizing  the 
crediting  of  overpayments  in  previous  years  against  any  income 
or  profits  taxes  due  the  United  States;   limiting  the  collection 
of  additional  taxes  to  a  period  within  five  years  after  they  were 
originally  due,  by  forbidding  suits  after  the  expiration  of  five 
years  from  the  due  date  of  the  return  except  in  case  of  fraud 
(the  previous  rule,  founded  on  the  principle  that  the  statute  of 
limitations  does  not  run  against  the  Government,  being  that 
taxes  could  be  collected  at  any  time  by  suit,  even  though  the 
period  during  which  assessment  might  be  made  had  passed) ; 
limiting  the  profits  tax  to  certain  percentages  designed  to 
benefit   the  small  corporation;  most  important  of  all,  per- 
haps, the  authority  to  determine  the  amount  of  the  profits 
tax  under  certain  conditions  by  comparison  with  representative 
concerns  and  the  creation  of  an   "Advisory  Tax  Board'^  to 
whom  the  taxpayer  might  appeal  for  a  reversal  of  decisions 
which  he  believed  to  be  erroneous  or  unjust. 

The  more  important  provisions  of  the  first  class,  such  as 
amortization  and  inventory  losses,  have  been  covered  in  detail 
in  previous  papers,  and  of  them  I  will  only  say  that  two  at 
least,  which  at  the  time  the  act  was  passed  were  expected  to 
afford  substantial  relief  in  many  cases,  have  been  practically 
inoperative  because  the  conditions   they  were  designed   to 
relieve  did  not  materialize,  and  since  they  were  limited  to  the 
year  1919,  they  are  not  available  for  relief  in  1920,  when  those 
conditions  have  arisen  in  a  number  of  important  industries.    I 
refer  to  the  provisions  for  throwing  back  or  forward  as  a  deduc- 
tion allowable  in  the  previous,  or  succeeding  year,  if  necessary, 
net  losses  from  operations  in  1919  and  inventory  losses  sus- 
tained in  1919,  through  shrinkage  during  that  year  in  the  value 
of  closing  inventories  of  1918.    The  anticipated  shrinkage  in 
values  and  decline  in  profits  appears  to  have  taken  place  in 
1920  instead  of  1919,  and  consequently  the  claims  for  net  loss 
have  been  few  in  number,  and  the  Treasury's  interpretation  of 
the  inventory-loss  provision,  holding  that  the  inventory  must 
be  considered  as  a  whole,  practically  eliminated  that  from  con- 
sideration,  as  there  were  few  instances  where  it  could  be 
shown    that    there   had    been  in  1919  a  substantial   loss   in 


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252       COLUMBIA     INCOME     TAX     LECTURES 

disposing  of  the  closing  inventory  of  191 8  taken  as  a  whole. 

Perhaps  there  was  no  one  thing  which  so  exasperated  the 
taxpayer  and  violated  his  sense  of  fairness  and  justice  as  that 
practice  of  the  Treasury,  necessitated  under  former  laws,  re- 
quiring him  to  pay  at  once  the  whole  amount  of  any  additional 
tax  found  due  for  any  given  year  upon  the  audit  of  his  books, 
although  the  same  audit  might  disclose  and  the  Treasury  con- 
cede that  for  another  year  he  had  overpaid  his  taxes,  for  which 
overpayment  he  was  told  he  might  make  a  refund  claim, 
usually  resulting  in  a  wait  of  a  year  or  more  for  his  money. 

This  was  cured  in  the  Revenue  Act  of  191 8,  by  authorizing 
the  filing  of  a  claim  for  credit  of  any  overpayment  of  tax 
against  any  tax  due  from  him,  resulting  in  his  paying  in  cash 
only  the  net  balance  against  him.  There  is  some  misapprehen- 
sion as  to  the  effect  of  the  acceptance  of  such  a  claim  by  the 
Collector,  so  it  may  be  well  to  state  that  the  filing  of  a  claim 
for  credit  or  its  acceptance  by  the  Collector  does  not  in  itself 
extinguish  any  liability.  It  merely  has  the  effect  of  a  claim  for 
abatement,  serving  by  forbearance  of  the  Collector  to  delay 
payment  until  acted  on  by  the  Commissioner.  If  allowed,  it  of 
course  wipes  out  an  equal  amount  of  liability;  if  disallowed, 
collection  is  made  of  the  amount  in  suspense  with  interest. 

Another  important  administrative  relief  provision  is  that 
which  in  effect  places  the  taxpayer  and  the  Government  on  an 
equal  footing  with  respect  to  the  bar  of  limitations,  by  pro- 
viding that  no  assessment  shall  be  made  or  suit  instituted  by 
the  Government  after  five  years  from  the  due  date  of  the  return, 
except  in  fraud  cases,  and  that  no  claim  for  refund  shall  be 
considered  unless  made  within  the  same  period. 

It  will  be  noted  that  time  begins  to  run  from  the  same  date 
against  both  the  taxpayer  and  the  Government,  and  an  awk- 
ward situation  might  arise  under  a  literal  interpretation  of  this 
statute  standing  alone,  since  if  the  Government  waits  until  the 
last  few  days  of  the  period  before  making  assessment,  the 
taxpayer's  five  years  may  have  elapsed  before  he  is  even  called 
on  for  payment.  This  possibility  has  been  averted  by  the 
Treasury's  very  fair  ruling  that  the  statute  was  not  intended  to 
abrogate  the  taxpayer's  right  under  the  Revised  Statutes  to 


RELIEF    PROVISIONS    AND    APPEALS 


253 


make  claim  for  refund  at  any  time  within  two  years  after  pay- 
ment. 

The  determination  of  the  profits  tax  by  comparison  with  rep- 
resentative concerns,  required  or  authorized  by  Sections  327 
and  328  of  the  law,  corresponding  with  Section  210  of  the 
Revenue  Act  of  1917,  as  interpreted  by  the  Treasury,  gives 
rise  to  one  of  the  most  difficult  and  unsatisfactory  situations  in 
the  administration  of  the  law,  since  the  result  depends  entirely 
on  the  comparatives  used,  and  the  selection  of  comparatives  is 
wholly  a  matter  of  judgment. 

The  Treasury  has  endeavored  to  meet  the  situation  by 
classifying  all  industry  into  major  divisions,  such  as  manufac- 
turing, trading,  financial,  transportation,  etc.  These  divisions 
are  subdivided,  manufacturing,  for  example,  into  concerns 
manufacturing  textiles,  iron  and  steel,  etc.,  the  process  of  sub- 
division being  repeated  until  the  groups  are  comparatively 
narrow.  It  is  when  we  come  to  compare  corporations  belong- 
ing in  the  same  final  group  that  the  difficulty  begins.  There  are 
so  many  factors  entering  into  the  problem  that  the  decision  as 
to  which  should  be  used  in  the  final  analysis  is  more  or  less 
arbitrary.  When  the  ground  for  applying  these  sections  has 
been  some  abnormality  of  income  or  invested  capital,  my  own 
method  of  approach  has  been  to  figure  out  what  the  tax  would 
have  been  had  the  abnormality  not  existed,  regarding  the 
amount  so  found  as  the  equitable  tax,  and  then  selecting  com- 
paratives that  would  result  in  approximately  this  figure.  This, 
however,  is  not  always  practicable. 

Since  to  disclose  the  names  of  the  comparatives  used  would 
in  effect  disclose  information  as  to  their  taxes,  which  the  law 
forbids,  it  is  impossible  in  many  instances  to  satisfy  the  tax- 
payer that  he  has  been  fairly  dealt  with. 

Perhaps  it  is  a  misuse  of  terms  to  speak  of  the  Committee  on 
Appeals  and  Review  as  one  of  the  relief  provisions  of  the  law, 
since,  technically,  it  is  not  specifically  authorized  by  the  law 
itself,  but  is  a  creation  of  the  Treasury  to  take  the  place  of  the 
Advisory  Tax  Board  provided  by  the  law  for  a  limited  period 

of  time. 

I  can  perhaps  best  give  you  a  comprehensive  view  of  the 


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254       COLUMBIA     INCOME     TAX     LECTURES 

need  for  such  an  organization  by  sketching  for  you  as  a  back- 
ground something  of  the  development  of  internal  taxation  as 
imposed  by  the  federal  government.  Most  of  us  who  have 
had  no  occasion  to  consider  or  study  the  history  of  taxation, 
are,  I  think,  prone  to  regard  internal  revenue  taxes  as  some- 
thing which,  like  poverty,  we  have  always  had  with  us,  as  we 
surely  always  will  have  in  the  future.  Such,  however,  is  not  the 
case,  and  for  long  periods  in  the  history  of  the  country,  there 
have  been  no  internal  federal  taxes  imposed. 

Excluding  proceeds  of  borrowings,  as  not  being  in  a  proper 
sense  revenues  at  all,  and  also  excepting  postal  revenues,  and 
some  minor  miscellaneous  sources  of  income,  the  revenues  of 
the  federal  government  are  derived  from  two  sources;  duties 
on  the  importation  of  foreign  merchandise  into  the  country, 
and  internal  taxes,  the  latter  being  divisible  into  two  classes, 
direct  taxes  and  indirect  taxes. 

Direct  taxes  have  been  specifically  imposed  only  twice  during 
the  history  of  the  nation,  and  as  they  must  be  apportioned 
among  the  states  according  to  population  and  not  accord- 
ing to  wealth,  they  are  not  likely  to  be  resorted  to  again. 

The  first  internal  tax  was  an  excise  tax  on  distilled  spirits 
imposed  by  an  Act  of  Congress  passed  early  in  1791.  This  act 
met  with  much  objection  and  opposition,  which  was  carried  to 
such  an  extent  that  in  1794  it  was  deemed  necessary  to  call  out 
the  militia  of  four  states  to  the  number  of  15,000  men,  to  put 
down  the  so-called  "W^hisky  Rebellion"  in  Pennsylvania. 

This  act  was  followed  by  other  laws  passed  in  1794,  levying 
taxes  on  carriages  used  as  conveyances,  on  licenses  for  selling 
wines  and  foreign  distilled  spirits,  on  snuff  and  sugar  refined 
in  this  country,  and  in  1797,  imposing  certain  documentary 
stamp  taxes. 

In  1802,  all  of  these  taxes  were  repealed  and  from  that  year 
until  following  the  war  of  1812,  the  country  got  along  without 
internal  federal  taxes.  In  18 13,  on  account  of  the  expense 
incurred  during  the  war  of  1812,  most  of  the  taxes  repealed  in 
1802  were  reimposed  with  some  additional  ones.  These  taxes 
remained  in  force  from  1813  to  181 7,  when  they  were  again 
repealed,  and  then  followed  a  long  period  during  which  the 


RELIEF    PROVISIONS    AND    APPEALS 


255 


revenues  from  imports  sufficed  to  meet  the  revenue  needs  of 
the  country,  and  during  which  it  was  free  from  internal  revenue 
bedevilment.  This  happy  condition  lasted  indeed  until  the 
outbreak  of  the  Civil  War  made  it  necessary  to  use  every  possi- 
ble available  means  for  raising  the  money  necessary  to  carry 
on  the  war.  In  1861,  an  act  was  passed  levying  a  direct  tax  of 
$20,000,000,  and  also  providing  for  an  income  tax.  The  income 
tax  features  of  this  act  were  never  put  in  force,  and  the  officers 
provided  for  by  it  were  never  appointed,  as  Congress  in  1862 
passed  a  much  more  comprehensive  scheme  of  taxation.  This 
Act  of  1862  provided  for  the  creation  and  organization  of  an 
internal  revenue  service,  which  has  existed  with  some  modifica- 
tions to  this  day. 

This  law  was  very  broad  in  its  scope,  providing  for  an  income 
tax  as  well  as  taxes  on  most  occupations  and  commodities 
capable  of  yielding  revenue.  With  some  amendments  and 
modifications,  it  remained  in  force  for  several  years,  and  some 
of  the  commodities  taxed  under  it,  as  for  instance,  distilled 
spirits,  fermented  liquors,  cigars  and  tobacco,  have  borne  the 
principal  burden  of  internal  revenue  taxation  up  to  very  recent 

times. 

The  income  tax  provisions  of  this  act,  which  served  as  a 
basis  for  the  drafting  of  the  later  Act  of  1913,  were  continued 
in  force  until  1872.  Curiously  enough,  this  income  tax  does 
not  appear  to  have  been  attacked  as  unconstitutional,  at 
least  on  the  grounds  which  resulted  in  the  well  known  Supreme 
Court  decision  in  the  Pollock  case,  holding  the  similar  provi- 
sions of  the  Act  of  1893  invalid  as  being  in  effect  direct  taxes 
not  levied  under  the  rule  of  apportionment,  as  required  by  the 
Consritution.  Compararively  little  litigation  appears  to  have 
resulted  from  this  act,  although  one  decision  of  the  Supreme 
Court  under  it,  that  rendered  in  the  case  of  Gray  v.  Darling- 
ton, has  remained  as  more  or  less  of  a  stumbling  block  to  the 
lawyers  of  today  in  construing  recent  legislation. 

By  1872,  most  of  the  internal  taxes  except  those  on 
liquors  and  manufactures  of  tobacco  had  been  repealed  and 
with  the  exception  of  a  short  period  following  the  Spanish- 
American  War  of  1898,  those  commodities  furnished  the  prin- 


* 


'Jl 


i 


256   COLUMBIA  INCOME  TAX  LECTURES 

cipal  sources  of  internal  revenue  for  some  forty  years  or  more. 
Although  an  excise  tax  measured  by  income  was  imposed  in 
1909,  on  the  privilege  of  doing  business  as  a  corporation,  it 
was  not  until  after  the  constitutional  amendment  authorizing 
the  levy  of  an  income  tax  without  apportionment  was  ratified, 
in  1913,  that  income  taxes  became  an  important  feature  of 
internal  taxation. 

I  have  gone  at  such  length  into  the  history  of  the  develop- 
ment of  internal  revenues  for  the  purpose  of  emphasizing  the 
fact  that  Congress  has  in  recent  years  adventured  into  prac- 
tically virgin  fields  of  taxation  by  the  passage  of  laws  which 
have  been  on  the  statute  books  so  short  a  time  that  there  is  no 
established  body  of  authoritative  court  opinion  to  serve  as  a 
guide  for  the  determination  of  many  of  the  difficult  and  intri- 
cate questions  which  daily  arise  in  connection  even  with  the 
income  tax  law,  not  to  speak  of  these  inherent  in  the  even 
more  difficult  field  of  profits  taxes.     Even  such  fundamental 
questions  as  "What  is  income?"  and  "When  does  it  become 
taxable?"  are  still  questions  which  give  rise  to  much  dispute 
and  argument,  for  the  reason  that  the  principles  governing  their 
determination  are  not  yet  clearly  and  authoritatively  estab- 
lished. 

It  must  be  remembered,  too,  that  the  Government  is  endowed 
with  very  broad  powers  of  summary  process  in  the  collection 
of  its  revenues.     Its  policy  is  and  always  has  been  to  collect 
first  and  litigate  afterwards,  in  the  case  of  disputes  with  the 
taxpayer.    The  Collector  is  charged  with  the  amount  of  any 
assessment  sent  to  him  and  is  liable  under  his  bond  as  Col- 
lector for  the  amount,  if  he  fails  to  use  due  diligence  in  collec- 
tion.    If  a  tax  is  not  paid  within  ten  days  after  notice  and 
demand,  he  is  authorized  to  issue  a  warrant  of  distraint,  which 
has  the  force  and  effect  of  an  execution  upon  a  judgment.  Un- 
der it,  he  may  seize  and  sell  at  public  auction  any  property  he 
can  find  belonging  to  the  taxpayer,  in  satisfaction  of  the  tax, 
and  under  express  provision   of   the  statute,   no  court  can 
interfere  to  stay  his  action.    The  only  recourse  the  taxpayer 
has  in  such  case  is  to  sue  for  the  recovery  of  the  amount  col- 
lected.   It  has  been  said  that  a  redress  is  provided  by  the  courts 


RELIEF    PROVISIONS    AND    APPEALS 


257 


for  every  wrong,  but  this  is  possibly  the  exception  which  proves 
the  rule.  While  real  estate,  if  sold  by  the  Collector,  may 
be  redeemed  within  a  certain  period,  if  personal  property  is 
sold,  it  is  gone  beyond  redemption,  and  even  if  the  tax  was  not 
properly  levied,  the  taxpayer  can  recover  in  the  court  only  the 
amount  for  which  it  sold,  which  may  have  been  far  less  than 

its  real  value. 

I  think  I  have  said  enough  to  show  the  absolute  need  of 
some  provision  whereby  the  taxpayer  may  be  assured  of  a 
thorough  and  painstaking  review  of  his  case,  in  the  event  of 
differences  of  view  between  himself  and  his  counsel  and  the 
assessing  officers,  before  recourse  is  had  to  such  drastic  meas- 
ures for  collection,  and  it  was  to  meet  this  need  that  the  Com- 
mittee on  Appeals  and  Review  was  created. 

In  order  to  function  successfully,  it  is  essential  that  the 
Committee  deserve  and  win  the  confidence  of  the  tax-paying 
public,  not  only  in  its  ability,  but  in  its  fairness  and  imparti- 
ality as  well. 

Its  personnel  was  accordingly  selected  from  those  officers  of 
the  Bureau  who  have  not  only  had  long  experience  and  the 
greatest  possible  familiarity  with  tax  problems,  but  who  have 
also  demonstrated  that  they  have  the  judicial  temperament 
and  can  be  relied  on  to  reach  fair  and  impartial  conclusions 
regardless  of  the  result. 

Further,  to  avoid  any  suggestion  of  prejudice  or  influence  in 
favor  of  the  views  or  position  of  the  Income  Tax  Unit,  the  Com- 
mittee was  taken  out  of  its  jurisdiction,  and  is  responsible  only 
to  the  Commissioner  and  Secretary  of  the  Treasury. 

Shortly  before  leaving  the  service,  being  curious  as  to 
exactly  what  extent  the  Committee  had  afforded  relief  to 
the  taxpayer  in  actual  practice,  I  had  an  examination  made 
of  all  of  its  recommendations,  and  found  that  in  forty  per 
cent,  of  all  the  cases  handled,  it  had  reversed  the  Unit,  and 
allowed  the  taxpayer's  claims  in  full;  in  thirty-seven  per  cent, 
it  had  supported  the  Unit  and  rejected  the  taxpayer's  con- 
tentions; and  in  twenty-three  per  cent,  it  had  in  part  sup- 
ported the  taxpayer's  claims  and  in  part  the  views  of  the  Unit. 
This  is  sufficient,  I  think,  to  refute  any  suggestion  that  the 


,i. 


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258      COLUMBIA     INCOME     TAX     LECTURES 

Committee    is    unduly    prejudiced    in    favor    of    the    Unit. 

The  Committee  consists  of  five  members,  three  of  whom 
have  given  their  entire  time  to  its  work,  and  the  other  two, 
the  Head  of  the  Internal  Audit  and  Head  of  the  Review  Divi- 
sion, sit  in  on  the  final  determination  of  cases.  The  latter 
two  are  not  ex-officio  positions,  but  the  men  occupying  them 
were  selected  because  of  their  peculiar  fitness  for  the  work. 
Upon  the  recent  resignation  of  Mr.  Murphy,  Head  of  the 
Internal  Audit  Division,  his  place  on  the  Committee  was 
filled  by  a  member  who  will  give  his  entire  time  to  the  work, 
making  four  now  so  engaged. 

The  Committee  has  practically  no  formal  set  rules  of  pro- 
cedure, except  (i)  that  it  will  not  consider  an  appeal  until  the 
Income  Tax  Unit  has  rendered  a  final  decision,  so  that  the  ap- 
pellant has  something  definite  from  which  to  appeal,  and  (2) 
that  any  facts  upon  which  the  appeal  is  based  must  be  suc- 
cinctly stated  in  writing  and  sworn  to.  The  procedure  after 
an  appeal  is  duly  filed  is  informal,  the  object  of  the  Committee 
being  to  get  at  the  real  facts  and  the  amount  of  tax  rightly  due. 

The  routine  of  handling  the  work  is  as  follows:  The  appeal 
in  writing,  stating  the  decision  of  the  Unit  which  is  objected 
to  and  from  which  appeal  is  taken,  may  be  filed  either  with 
the  Unit  or  directly  with  the  Committee's  secretary.  In  the 
latter  case,  a  card  record  is  made  and  the  Income  Tax  Unit 
notified  that  an  appeal  has  been  taken  and  requested  to 
forward  all  papers,  with  such  memoranda  explaining  its 
position  and  the  reasons  for  its  action  as  it  cares  to  submit. 
Upon  receipt  of  the  complete  file,  it  is  placed  in  a  pending  file 
until  such  time  as  a  member  of  the  Committee  notifies  the 
secretary  that  he  is  ready  to  take  on  more  cases.  The  earliest 
ones  received  are  then  assigned  to  him,  and  a  cursory  examina- 
tion made  to  see  if  an  oral  hearing  is  desired.  If  it  is,  the 
secretary  makes  an  appointment  by  correspondence  with 
the  appellant,  suggesting  that  briefs  of  his  argument  upon  the 
questions  raised  by  the  appeal  be  filed  at  least  three  days 
before  the  hearing.  This  is  for  the  purpose  of  giving  the 
member  who  will  hear  the  case  an  opportunity  for  a  pre- 
liminary study  of  the  questions.     The  Unit  is  also  notified. 


RELIEF    PROVISIONS    AND    APPEALS 


259 


so  that  the  auditor  whose  conclusions  are  questioned  may  be 
present,  and  the  Solicitor  as  well,  if  any  question  of  law  seems 
to  be  involved.     After  the  hearing,  the  member  carefully 
studies  the  facts  which  have  been  brought  out,  and  the  law 
and  regulations  applicable  to  the  case,  and  formulates  his 
conclusions  in  writing  in  the  form  of  a  proposed  Committee 
Recommendation.     Copies  of  this  are  furnished  each  of  the 
other  members,  and  at  least  once  a  week,   or  oftener,   if 
necessary,  all  members  meet  in  conference  for  a  consideration 
of  the  opinions  so  prepared.     In  these  conferences,  the  facts 
and  treatment  of  them  are  fully  discussed,  and  if  the  various 
members  are  satisfied  that  the  recommendations  as  prepared 
are  sound  and  proper,  they  are  signed  by  the  Chairman  and 
forwarded  to  the  Commissioner  for  his  approval.    If  there  are 
differences  of  opinion,  these  are  threshed  out  until  all  can 
agree,  if  possible.    If  it  is  not  possible  to  reach  an  unanimous 
opinion,  the  majority  view  prevails,  and  the  opinion  is  sent 
back,  if  necessary,  for  rewriting  in  accordance  with  the  view 
held  by  the  majority. 

The  questions  submitted  to  the  Committee  are  of  course 
very  varied.    Sometimes  they  are  submitted  mainly  because 
the  taxpayer  is  indisposed  to  pay  the  tax  demanded  until  he 
has  exhausted  every  opportunity  of  escape  by  appealing  to  the 
last  authority.     These   are   few   in   number,   however,   and 
ordinarily  each  one  presents  a  real  question.    Sometimes  it  is 
a  problem  of  correct  construction  of  the  law  and  regulations; 
sometimes  as  to  the  regulation  applicable  to  a  particular  state 
of  facts.     Most  frequently,  perhaps,  it  is  a  question  of  the 
exercise  of  discretion  or  judgment.     It  must  be  remembered 
that  many  times  large  taxes  hinge  upon  questions  of  fact 
which  are  not  capable  of  positive  proof,  and  as  to  which  a 
conclusion  must  be  reached  in  the  light  of  the  best  evidence 
obtainable.     Upon  such  questions  minds  will  differ  widely. 
Examples  of  this  kind  of  cases  are  those  involving  valuation 
of  assets,  tangible  or  intangible,  at  the  time  when  paid  in  for 
stock  years  ago,  affecting  invested  capital,  or  as  of  March  i, 
1913,  when  subsequently  sold,  involving  the  extent  of  the 
profit  or  loss  when  sold.    Other  examples,  which,  incidentally, 


I 


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260      COLUMBIA     INCOME     TAX     LECTURES 

constitute  a  very  large  and  difficult  class,  are  those  arising 
from  the  disallowance  of  a  part  of  the  salaries  of  officers  claimed. 
The   Treasury    seldom,    if   ever,    questions   salaries   paid   as 
the  result  of  open  bargaining  between  the  company  and  the 
officer,  if  the  latter  is  not  a  stockholder,  and  the  question  most 
frequently   comes   up   when   the   officers   own   a   controlling 
interest  and  are  able  to  vote  themselves  such  salaries  as  they 
see  fit.    Prior  to  1916,  the  tax  on  corporations  was  at  the  same 
rate  as  the  normal  tax  on  individuals,  and  the  salary  claimed 
made  no  difference.     If  the  corporation  claimed  a  deduction 
for  salary  paid  the  recipient  paid  normal  and  surtax  on  it. 
If   profits  were   distributed   as   dividends,   and    not    in    the 
guise  of  salaries,  the  corporation  paid  tax  and  the  recipient 
paid  no  normal  tax  on  the  amount.    The  Government  received 
the  same  amount  in  either  case.     With  the   coming  of   the 
excess  profits  tax,  however,  all  this  changed,  and    in    many 
cases  the  advantage  of  distributing  profits  as  salaries  was  very 
great,  hence  the  necessity  of  a  close  scrutiny  of  salary  allow- 
ances. 

Possibly  the  most  difficult  cases  to  discuss  intelligently  with 
the  taxpayer  are  those  where  assessment  under  the  law  is 
determined  by  comparison  with  other  taxpayers  in  a  similar 
line  of  business,  because  of  inability  to  determine  the  tax- 
payer's true  invested  capital,  or  because  of  the  existence  of 
some  of  the  other  grounds  under  the  law  for  such  action.  This 
is  because  the  facts  which  are  the  basis  for  the  conclusion 
reached  cannot  be  disclosed  to  the  taxpayer,  for  the  reason 
that  to  do  so  might  give  him  an  insight  into  some  other  tax- 
payer's affairs,  which  the  officer  is  forbidden  by  law  to  do. 
Consequently  about  the  only  specific  ground  for  complaint 
that  he  can  ordinarily  present  is  his  belief  that  the  tax  is  too 
high,  as  a  result  of  using  unfair  comparatives.  As  he  does  not 
know  what  comparatives  were  used,  he  is  at  a  decided  dis- 
advantage in  presenting  his  side  of  the  case. 

Whatever  the  character  of  the  case,  whether  the  appeal 
seems  frivolous  or  well-founded,  whether  the  amount  involved 
is  trivial  or  huge,  the  case  receives  the  most  careful  scrutiny  to 
make  as  sure  as  possible  of  the  soundness  of  the  principles 


RELIEF    PROVISIONS    AND    APPEALS  26I 

involved.  Precedents  are  fearsome  things  in  the  administra- 
tion of  the  law,  and  the  decision  of  a  case  upon  an  unsound 
basis  of  principle  may  set  up  a  precedent  which  it  will  be  very 
awkward  to  ignore  later. 


I 


1 


INDEX 


'flii 


Accountant's  view  of  taxable 

income 11-13.  16-18 

Accounting,  23-25,  27;  income 
when  realized,  30-31;  method 
prescribed,  111-2;  suggestions 
for  taxation  of  natural  resources, 
246-9 
Acts  or  occupations,  taxes  on   .     58 

Adams,  Thomas  S 29-50 

Administration,  imperfections  of  16- 

19,  24-27,  29-30,  109-111,  118 
Affiliated    corporations     ques- 
tionnaire   192 

Aliens,  deductions  for  losses  .    158-9 
Amortization  of  war  facilities,  153- 

7;  relief  provisions  for,  251-2 
Anderson  v.  Forty-Two  Broad- 
way Co.,  62  (footnote),  63  (foot- 
note) 
Animals,  imported     .    .    .    101-102 
Appeals  and  relief  provisions.    {See 

Relief  provisions  and  appeals) 
Appeals,  Committee  on     .  253-261 
Appreciations  taxable    .     I5i  24-25 

Assessment      92-94 

Automobiles,  depreciation  of  .    140 
Average  cost,  inventory  method,  181 

Ballantine,  Arthur  A.,  59,  61,  90, 
160-187 

Baltic  Mining  Case 88 

Bank  of  California  v.  Richard- 
son     53  (footnote) 

Bank    of    Commerce   v.    New 

York  City  ....  53  (footnote) 
Bank  Tax  Case  ...  53  (footnote) 
Base  stock,  inventory  method,  18 1-2 
Bates  &  Guild  Co.  r.  Payne  .  .  106 
Billings  V.  United  States,  56  (foot- 
note), 58  (footnote),  60  (footnote) 


Bonds,  75;    Liberty  bonds,  41-43. 
114,    120;     exemptions   for   con- 
solidated corporations,  221 
Boske  V.  Comingore   ....   9^-99 
Brandeis,  Justice  Louis,   59   (foot- 
note) 
Brewster  v.  Walsh  .   .  10  (footnote) 
British,  etc.    {See  under  Gt.  Britain) 
Brushaber  v.  Union  Pacific  R.  Co., 
57-58    (footnotes),   61-62    (foot- 
notes), 63,  73  (footnote),  85-86, 1 13 
Building  and  loan  associations,  41 ; 

leases,  California,  104-5 
Business,  federal  tax  on,  58;   taxes 

60-61,  63,  68-69 
Buttfield   V.   Stranahan,   61    (foot- 
note), I 12-13 

California  District  Court  ruling, 

on  building  lease     .    .    .    104-105 
Capital  assets,  isolated  sales  of,  39-40. 
43,  49;  sales  of,  81-84 

Capitation  taxes 57 

Cash  equivalence,  29-30,  32,  36-43, 

120-1,  124-6,  129-31,  133-4 
Casualties,  losses  from  .  .  .  158-9 
Central  Pacific  R.  Co.  .  .  .  78-79 
Chain  stores,  inventory  of  .  .  166 
Charitable  contributions  .  .  25-26 
Chase,  Chief  Justice,  59  (footnote) 

Cheatham  v.  U.  S 106 

Child  labor 6l 

Clark,  Justice 97 

Clark,  Charles  E.   .    .70  (footnote) 
Cleveland,  Cincinnati,  Chicago 
and    St.    Louis    R.    Co.,    v. 

Backus 228 

Closed    transactions,     114,     11 8-9 

120-4,  133.  136 
Clothing,  depreciation  of    .    .      140 


■M 


u 
ll 


Hi 


264      COLUMBIA     INCOM 

Coal  mining,  depletion  ....  226 

Cohn,  Gustav 21 

Collector    v.    Day,    53    (footnote), 

58  (footnote) 
Commercial  instruments,  56;  stamp 
taxes  on,  56  (footnote) 

Commingled  goods 172 

Committee  on  Appeals  .    .     253-61 
Compensation  for  personal  ser- 
vice,    interest,     rents     and 

dividends 4^~43 

Computation  methods  ....    109 
Concept  of  Income    ....     1-28 
Consigned  goods,  inventory  of  .   169 
Consolidated  returns,  188-221;  ori- 
gin and  history  (188-190)  what 
corporations  should  make  a  con- 
solidated return,  190-4;   partner- 
ship and  owned  corporations,  194; 
advantages    and    disadvantages, 
194-5;    determining  consolidated 
income,     195-200;      determining 
consolidated  invested  capital,  200, 
inadmissible   assets,    201-7;     in- 
tangible property,  207-9;  invest- 
ments in  stocks  of  subsidiaries, 
209-16;  pre-war  consolidated  in- 
vested capital,  216-7;    losses  in 
pre-war     period,     217-9;      stock 
dividends,  219;  change  in  owner- 
ship during  taxable  year,  219-20; 
difference    in    fiscal    years,    221; 
exemptions,  221;   information  re- 
turns, 221 
Constitutional  Aspects      .    .   51-90 
Construction  companies    ...     36 
Contract,  firm,  in  inventory  .       175 
Contracting  companies     .       36,  38 
Copyrights,  depreciation  of  .    .    141 
Cornell  v.  Coyne     .    .   56  (footnote) 
Corporate  dividends,  84-5;    stock, 

41-3.  72,  82-3,  89-90 
Corporation  excise  tax  of  1909,  32, 
'    47.  53-55,  62,  68-69,  74,  78,  81; 

gains,  63-66 


E     TAX     LECTURES 

Corporation    Trust    Co.'s    In- 
come Tax  Service 32 

Cost  or  market,  whichever  is 
lower   162,  17 1-2,  180,  198-9,  212 

Costs 33-34,  48-49 

Court  decisions 45-50 

Court   of   Claims,   concept   of 

income      45-4^ 

Crop  sales 3** 

Cryan  v.  Wardell 104 

Darlington  Case .  75.  77.  7^8o,  255 
Day,    Justice,    54-55,    57,    58-59 

(footnotes) 
Debts,  32;  corporations,  62 
Deduction  for  losses   ....   85-89 
De  Ganey  v.  Lederer,  59  (footnote), 

104,  107 
Depletion,  of  natural  resources, 

224-249 

Depreciation  of  property,  138-151; 
kind  of  property  subject  to,  139- 
141;  value  provided  for,  141-3; 
measure  of  annual  allowance, 
143-7;  incidental  repairs,  147-8; 
renewal  of  parts,  148;  additions 
and  betterments,  148;  excessive 
or  inadequate  deductions,  148-50; 
depreciation  reserves,  150-1;  in 
inventory,  168 
Dickinson,  A.  Lowes     .    .    .  12,  15 

Dillon,  Judge 60 

Direct  taxation,  53-54.  57-58,  84, 

87-88,  254 
Distilling  of  spirits.    {See  Liquor) 
Dividends.  {See  Stock  dividends) 
Dobbins  v.  Erie  County,  53  (foot- 
note) 
Dollar  Savings  Bank  v.  U.S.,  93 
(footnote),  108 

Double  tax 6-7,  8^-90 

Doyle  V.  Mitchell  Bros.  Co.,  47,  72 
(footnote),  74i  76,  81,  103,  117, 

125 
Drygoods,  inventory  of     ...   174 


INDEX 


265 


Duties 57 

Edwards  v.  Darby      108 

Edwards  v.    Keith,   42    (footnote), 
104,  109 

Einaudi,  Luigi 7 

Eisner  v.  Macomber,  8  (footnote), 
70,  72  (footnote),  80,  116,  121 

Ely,  Richard  T 3 

England  {See  Gt.  Britain) 
Evans  v.  Gore     ...  58  (footnote) 
Excess  profits,  61,  90;   law  in  Ger- 
many, 23;   in  England,  25;   con- 
solidated   returns,    198;     theory 
of,  210;   pre-war,  217-19 
Exchange,  of  property,  23,  1 14-15, 
I18-122,  126,  131-6,  146;  foreign 
money  in  inventory,  186 
Excise  tax,  of  1909,  32,  47,  53-55. 
62,  68-69,  74,  78,  81;  on  acts  or 
occupations,  55-57 
Exemptions,    of    savings,    legacies, 
wages,  20;    for  consolidated  cor- 
porations, 221 
Extraordinary  Dividend  Cases,     73 

Fairbanks  v.  U.  S.  .    .  56  (footnote) 

Fairchild,   Fred   R.,   70   (footnote) 

Farming,  36,   38;    crop  sales,   30; 

mortgages,     65-66;      inventories 

for,  163,  178 

Fees      4i~43 

Field,  Fred  T 91-113 

Field,  Justice 80,  83 

Finlay's  Cost  of  Mining    ...   228 

Firm  contract 175 

First  Trust  &  Savings  Bank  v. 

Smietanka 105 

Fiscal  years  of  different  corpor- 
ations    221 

Fisher,  Irving 2,  12 

Flint  V.  Stone  Tracy  Company,  53 
(footnote),   54-55.    5^58    (foot- 
notes) 
Fordney,  Mr 125 


Foreign  corporations,  deductions  for 
losses,  158-9;  forbidden  to  make 
consolidated  returns,  192-4; 
money  exchange  in  inventory,  186 

Forest  reserves 97 

Franchises,  depreciation  of  .       141 
Fuller,  Chief  Justice   Melville 

Weston 57 

Futures,  inventory  of    ....   171 

Gas  and  oil  wells,  capital,  222;  de- 
pletion, 224-7,  238;  fair  market 
value,  236;  determination  of 
quantity  of  oil  in  the  ground,  238; 
depletion  allowance  for  combined 
oil  and  gas  wells,  239;  discovery 
of  wells,  241-2;  charges  to  capital 

244 
Gauley  Mountain  Case,  46,  50,  72 

(footnote),  75  (footnote),  76-77, 
103 
General    Motors   Co.   of   New 

Jersey 123-4 

German  concept  of  taxable  income, 
13,  20-21;  Excess  Profits  Law,  23 

Gifts,  taxable      25-26 

Goldfield   Consolidated    Mines 

Co.  V.  Scott 103 

Goodwill  and  obsolescence    .153 
Government.     {See  Administration, 
Treasury) 

Graton,  L.  C 227-8 

Gray  v.  Darlington,  75, 77, 79-80,  255 
Great  Britain,  appreciations  not 
taxable,  17;  opinion  of  our  Treas- 
ury, 19;  concept  of  income,  19- 
21,  137;  Increment  Value  Duty, 
21;  Excess  Profits  Law,  25; 
account  with  the  taxpayer,  39; 
system  of  income  taxation,  137-8; 
tax  on  trading  profits,  165;  rule 
of  valuation  bases,  171 

Haig,    Robert    Murray,    1-28,    25 
(footnote),  77 


266       COLUMBIA     INCOME     TAX     LECTURES 


INDEX 


267 


Hamilton  v.   Kentucky  Distilleries 

and  Warehouse  Co.,  59  (footnote) 

Hardy,  Mr 124 

Hardy  v.  Woodcock,  93  (footnote) 
Hays    V.    Gauley    Mountain    Coal 

Co.,    46,    50,    72    (footnote),    75 

(footnote),  7^77»  I03 
Heer,      Clarence,      6      (footnote), 

20  (footnote) 
Holmes,  George  E.,  45  (footnote), 

'.    137-159 

Holmes,  Justice  Oliver  Wendell, 

67,  71  (footnote) 

Homes  Savings   Bank  v.   Des 

Moines 53  (footnote) 

Homestead  claims  ....  97*^9 
Hoover's  Principles  of  mining,  228 
Hornby    Case,    52    (footnote),    62 

(footnote),  64-65,  72 


Imperfections,  of  the  administration, 
16-19,  24-27,  29-30,  109-111;  of 
the  economic  standard  of  value, 
16;  of  accounting  practice,  16,  18 

Imports 61 

Impost 57 

In  re  Kollock 98 

Inadmissible  assets     .    .194.  201-7 
Income  defined,   1-28,  82;    Italian 
concept  of,  7,  13,  20;  net  income, 
12-13,  16,  22-23,  31-33.  63,  75; 
German  concept  of,    13,   20-21; 
annual  income,  19-84;   history  of 
concept  of,   19-21;    British  con- 
cept of,    19-21,   25,    137;    when 
realized,  29-50,  73*77.  7^8o.  82- 
86,118;  Court  of  Claims,  concept 
of,  45-46;  by  Justice  Pitney,  67, 
78-82,  1 16-8;    by  Congress,  68- 
69,  71 ;  by  Supreme  Court,  70-71, 
116;    taxable   when   credited   to 
owner,    96-97;     computation    of 
tax,  100;  Income  Tax  Unit,  257-9 
Increment  Value  Duty      ...     21 


Indirect  taxation,  54-55.  57-58,  68, 

87-88,  254 
Information  returns  of  consoli- 
dated corporations     .    .    .    .221 

Inheritances 61,  89-90 

Instalment   plan   sales,   30,   36-37, 
132-4,  199  (footnote) 

Insurance  business 5^ 

Intangible  property 207 

Inter-company   profits.    {See   Con- 
solidated returns) 
Intercorporate  dividends  .    .   62-63 
Interest,  compensation  for    .  41-43 
Internal  revenue  taxes,  history 

of 254-6 

Inventories,  49,  93;  method,  135-6; 
functions  of,  160-3;  forms,  1 61-2; 
who  are  to  use  inventories,  163-4; 
when  they  must  be  taken,  164-5; 
how  they  must  be  taken,  165-6; 
what    to   be    included,    166-171; 
scrap,   167-9;    position  of  items, 
169-170;  "short"  items,  170;  val- 
uation  bases,    171-182;     cost   or 
market,  whichever  is  lower,  1 7 1-2; 
cost,   172-5;    of  goods  manufac- 
tured or  purchased,  172-173;  how 
cost  is  to  be  determined,  174;  cost 
systems,  175;   market,  175-8;   to 
what  items  applied,  175;  replace- 
ment cost,  175-6;  seconds,  176-7; 
proof  of  market  price,  177;   gov- 
ernment prices  for  19 18,  177-8; 
other  bases  of  valuation,  farmers 
and  growers  of  livestock,  lumber, 
tobacco,  178-9;   change  in  basis, 
179-180;     bases   not    permitted, 
market,  average  cost,  base  stock 
method,     181-2;      reserves     not 
permitted    as  deductions,  182-3; 
losses,     183-6;      goods     abroad, 
foreign  money,  186;  future  devel- 
opments,   186;    relief   provisions 
for  losses,  251-252 
Invested  capital,  consolidated,  200; 


pre-war    consolidated,    216-217; 
defined,  223 

Investments    in    stocks  of   subsid- 
iaries, 194,  203  (footnote),  209-16 

Investors,  not  to  use  inventories,  164 

Isolated  sales  of  capital  assets, 
39-40,  43,  49,  84 

Italian  concept  of  taxable  in- 
come      7,  13,  20 

Jacobs  r.  Pritchard 108 

Judges'  Salaries  Case     ....   103 

Kitchin,  Claude      124 

Knowlton  v.  Moore,  56  (footnote), 

61  (footnote) 
Kollock,  In  re 98 

Land  value.     {See  Property  value) 
Leases,  California       .    .    .    104-105 
Legal  Force  and  Effect  of  Treas- 
ury Interpretation  .    .    .    91-113 
Liberty    bonds,    41-43,    114,    120; 
exemptions  for  consolidated  cor- 
porations, 221 
Licenses,  depreciation  of  .    .    .   141 
Liquor,  distilling  of  spirits,  56,  60, 
254-5;    traffic  with  Indians,  97; 
War-Time  Prohibition  Act,  102; 
inventory  of»  169,  173,  185 
Livestock,  inventory  basis    .    .    178 
Living  quarters  in  addition  to 

salary 41 

Loss,  deduction  for,  85-89;  a  factor 
in  the  determination  of  income, 
137-159;  depreciation,  138-151; 
obsolescence,  15 1-3;  amortiza- 
tion of  war  facilities,  153-7;  losses 
due  to  casualties  and  thefts, 
158-9;  in  the  pre-war  period, 
217-19 
Lumber  business,  47,  72-75,  102, 
222;  depreciation  of,  140;  in- 
ventory of,  179,  181;  depletion, 
227,  245-6 


Lybrand,  William  M.,  201  (foot- 
note) 

Lynch  v.  Hornby,  52  (footnote), 
62  (footnote),  64-65,  72 

Lynch  v.  Turrish,  47,  50,  62  (foot- 
note), 78-79,  82 

McCray  v.  U.  S.,  56  (footnote),  60- 
61  (footnotes) 

McCulloch,  John  Ramsay    .    .     20 

M'Culloch  V.  Maryland,  53  (foot- 
note) 

McKenna,  Justice,  67,  72  (footnote), 
79-82 

McMillan  v.  Anderson  ....    107 

Machinery,  depreciation  of,  140, 
144-5,  147 

Macomber  v.  Eisner,  8  (footnote), 
70,  72  (footnote),  80,  116,  121 

Maintenance,    in    addition    to 
salary 41 

Manufacturing  business,  30-36,  43, 
46,  60;  returns  during  change  of 
ownership,     220;      classification, 

253 
Market  quotation,  in  inventory  177 

Marshall,  Alfred       3,  20 

Maryland  Casualty  Co.  v.  U.  S.  46 
(footnote),  97-98,  125 

Maxwell  v.  Bugbee 89 

Merchandising  business,  30-36,  43, 
46 

Mill,  John  Stuart 6,  20 

Mining  business,  30,  34-35,  62,  66- 
69,  70-71,  73-74.  86,  103;  in  Gt. 
Brit.,  21;  Depletion  Cases,  73; 
sale  of  ore,  84;  depreciation  of 
lands,  140;  inventory  of,  170; 
capital,  223-4;  depletion,  224- 
238;  principles  of  valuation, 
229-30;  calculation  of  valuation, 
231;  suggested  method  for  deple- 
tion, 231-38;  tables  of  percen- 
tages of  earnings,  232-5;  dis- 
count rate,  235-43;    fair  market 


f.  J 


•i 


4 


268       COLUMBIA     INCOME     TAX     LECTURES 


value,  235-7;  depletion  based  on 
advanced  royalties,  239;  dis- 
covery of  mines,  240-241;  allow- 
able capital  additions,  242-244; 
accounting,  246-9 
Montgomery,  Robert  H.,  12,  114- 

136 

Morehead  v.  U.  S.  .    .  97  (footnote) 

Morrill  v.  Jones 101-102 

Murray's   Lessee   v.    Hoboken 

Land   &    Improvement    Co. 

107  (footnote) 

National  Lead  Co.  v.  U.  S.  107-108 
Natural  resources,  taxation  of  in- 
come from  (222-249):  capital, 
223-4;  depletion,  224-38;  pres- 
ent value  of  eventual  earnings 
228;  principles  of  valuation,  229- 
30;  calculation  of  valuation,  231; 
suggested  method  for  depletion, 
231-5;  tables  of  percentages  of 
earnings,  232-5;  discount  rate, 
235;  capital  and  operating 
charges  on  mines,  243-6;  account- 
ing methods  suggested,  246-9 
New  Jersey,  extra-state  inheri- 
tance tax .     89 

New  York  Life  Insurance  Co.  v. 
Anderson,     93     (footnote),     138 
(footnote) 
Newman,  Francis  William   .    .     21 
Nicol  V.   Ames,   52    (footnote),   56 
(footnote),  60  (footnote),  87 

Norris,  R.  V 222-249 

Notes,  promissory,  41,  46;    issued 
by  a  bank,  56;  face  value,  60 

Obsolescence,  15 1-3;  inventory,  168 
Occupations,  taxable  .  .  .  55i  5^ 
Office    buildings,    depreciation 

of 14^7 

Oil  wells.    {See  Gas  and  oil  wells) 

Oleomargarine 61,  98 

Open    market    quotation,    in 


inventory 177 

Ores.    {See  Mining  business) 
Ownership,  change  of,  during 

the  taxable  year     .    .    .     219-20 

Pacific  Insurance  Co.  v.  Soule,  56 

(footnote) 
Partnerships,  and  consolidated 

returns I94 

Patents,  sale  of,  1 2 1-2;  depreciation 

of,  141 
Patton  V.  Brady     .    .   56  (footnote) 
Peabody  v.   Eisner,   52   (footnote), 

72;  statement  of  case,  64 
Peck  &  Co.  V.  Lowe,  57-58  (foot- 
notes) 
Peckham,  Justice,  52  (footnote),  87 

Personal  expenses 13 

Personal  property,  sale  of  .  132,  134 
Personal  services,  20,  23,  41-43 
Philippovitch,  Eugen     ....     21 
Physical    property,    inventory 

of 165-6 

Pitney,  Justice,  63,  65-^7»  72-78, 

80-82,  87,  1 16-18 
Pollock   V.   Farmers'   Loan   & 

Trust  Co.,    53.    55-56,    58,    76, 
87-88,  255 
Population,  tax  according  to  57-58, 

84,  88 
Powell.  Thomas  Reed  .  .   .    51-90 
Powell  V.    Pennsylvania,  61    (foot- 
note) 
Pre-war  consolidated  invested  capi- 
tal, 216-17;   losses,  217-19 

Prices 16-17 

Professional  services 104 

Progressive  inheritance  and  in- 
come taxation 89-90 

Prohibition  Act 102 

Promissory  notes 4J»  4^ 

Property,  values,  8,  10-21,  24-25, 
60,  79-80;  exchange  or  sale,  23, 
1 14-15,  1 18-122,  126,  131-6,  146; 
tax,  57-58,  64,  87-88;  gains  from 


INDEX 


269 


values,  74-75;    sale  of  personal 
property,    132,    134;     intangible, 
consolidated  returns,  207-9 
Psychological  view  of  income,  2-5, 

7,  20,  21 
Public  lands,  applicants  for  ,  97-99 
Public  tax  returns      96 

Rates  of  taxation   .    .    .  89-90,  146 

Real  estate,  sales 76 

Rech-Marbaker  v.  Lederer    .    .   107 

Records,  control  of 98 

Refund  of  taxes  .  .  94,  106-107 
Relief  provisions,  and  appeals,  (250- 
261):  amortization  and  inventory 
losses,  251-2;  overpayment  of 
taxes,  252;  no  assessment  shall 
be  made  after  five  years,  252-3; 
Committee  on  Appeals,  253-261 

Renewal  of  parts 148 

Rents,  compensation  for  .  .  41-43 
Reorganizations  and  the  Closed 

Transaction 1 14-136 

Repairs  on  property  ....  147-8 
Residences,  depreciation  of  .  .  139 
Retail  drygoods,  inventory  of,  174 
Revenue  taxes,  history  of     .   254-6 

Ricardo,  David       20 

Risk      13 

Roscher,  Wilhelm 20 

Royal  Commission  on  the  In- 
come Tax 25,  165 

Royalties  on  mines 239 

Sakolski,  A.  M.  .  .  .70  (footnote) 
Salaries,  41-43;  Judges'  Salaries 
Case,  103;  salaries  of  officials,  260 
Sales,  property,  23, 1 14-15, 1 18-122, 
126,  1 3 1-6,  146;  crop,  30;  instal- 
ment plan,  30,  36-37,  132-4,  199 
(footnote);  of  capital  assets, 
isolated,  39-40.  43.  49.  81-84;  of 
real  estate,  76;  of  capital,  78; 
wash,  86-87;    of  stock,   1 14-15, 


120-131,    170-171;     of    personal 
property,  132,  134 
Savings  banks  interest  ....     41 

Schanz,  Georg  von 20 

Schillinger's  case 35.  46 

Schmoller,  Gustav 20 

Scrap,  inventory  of  ...  .  167-9 
Second  Stock  Dividend  Case  .  74 
Seconds,  inventory  of  .  .  .  176-7 
Securities,  dealers  in,  not  to  use 

inventories 163 

Seligman,  Edwin  R.  A.,  i-iv,  3,  6,  8, 
12,  21,  77 

Separation  test 8 

Shoe  factories,  inventory  of  .166 
Simmons,  Senator  .    .    .    .  154,  156 

Smith,  Adam 19-20 

Snow,  Mr 67 

SnuflP  tax  in  1794 254 

Social  view  of  taxation      ...     19 
Southern  Pacific  Co.  v.  Lowe,  78,  86 
Spirits,  distilling  of.     {See  Liquor) 
Spreckels  Sugar   Refining  Co. 
V.    McClain,    56    (footnote),    60 
(footnote) 
Stamp    taxes    on    commercial 
instruments     ...  56  (footnote) 

Standard  of  value 16,  27 

Stanton  v.   Baltic   Mining  Co.   57 
(footnote),  67,  71  (footnote) 

Staub,  Walter  A 188-221 

Steamships,  depreciation  of,  146-7 
Stock  dividends,  i,  8-9,  21,  23,  65- 
66,  70-74,  81,  85-90,  103;  com- 
pensation, 41-43;  intercorporate, 
62-63;  corporate,  64,  66;  trading 
in,  77;  exchange  or  sale  of,  114- 
15,  120-131;  sales,  inventory  of, 
1 70-171;  of  subsidiaries,  invest- 
ments in,  194,  203  (footnote), 
209-16;  consolidated  returns,  219 
Stockdale  v.  Atlantic  Insurance 

Co 73  (footnote),  85 

Stone-Tracy    Case,    53     (footnote) 
54-55.  56-58  (footnotes) 


i 


270      COLUMBIA     INCOME     TAX     LECTURES 


Stratton's      Independence     v. 

Howbert,  48,  62   (footnote),  66, 

68,  117 
Subsidiary  corporations,  returns  of. 

{See  Consolidated  returns) 
Sugar  plantations,  depreciation  of, 

140;    inventory  of,    179;    tax  in 

1794.  254 
Sumner,  William  Graham     .    .     52 

Supplies,  inventory  of   .    .    .    .167 

Surplus 8,  10 

Swayne,  Justice      56-57 

Sweeney  v.  U.  S.     .    .  94  (footnote) 


Talbert,  P.  S 250-261 

Taussig,  Frank  William    .    .    .  2,  4 
Taxes,  collection  of,  93-94.  256-7; 
refunded,  106-7 

Tea,  importation  of 112 

Thames  &  Mersey  M.  Ins.  Co. 

t>.  U.  S 56  (footnote) 

Theft,  losses  from 158-9 

Thomas,  Judge  J.  D.,  10  (footnote) 
Thomas  v.  U.  S.  54  (footnote),  56-57 

(footnotes),  60  (footnote) 
Timber.   {See  Lumber) 
Tobacco,   inventory  of,    173,    I79» 

181;   internal  revenue  tax,  255 
Towne  v.  Eisner,  8  (footnote),  71 

(footnote);   103 
Tracy  v.  Swartout   109   (footnote) 
Treasury,   burden   upon   staff,    19; 
erroneous  rulings,  29-30,  109-1 1 1 ; 
rulings  in   particular  cases,   92- 
113:  interpretations  embodied  in 
acts  of,  94-95;   re-opening  closed 
cases,   iio-iii;    retroactive  rul- 
ings, 109-113 
Treat  v.  White    ...  56  (footnote) 
Trees,  depreciation  of    .    .   139-140 
Trust  estates 105 


Undistributed  surplus 
Unit,  Income  Tax  .    . 


8,  10 
257-9 


United  States  (cases  cited):  U.  S. 
V.  Bennett,  56  (footnote),  60 
(footnote);  U.S.  v.  Birdsall,  97 
(footnote) ;  U.  S.  v.  Cleveland, 
C.  C.  &  St.  L.  R.  Co.,  72  (foot- 
note), 77;  U.  S.  V.  Erie,  59  (foot- 
note); U.S.  V.  George,  99,  102; 
U.  S.  V.  Grand  Rapids  &  Indiana 
R.  Co.,  93  (footnote);  U.S.  v. 
Grimaud,  97  (footnote) ;  U.  S.  v. 
Hvoslef,  56  (footnote);  U.S.  v. 
Railroad  Co.,  53  (footnote),  58 
(footnote) ;  U.  S.  v.  Rindskopf, 
93  (footnote);  U.  S.  v.  Schillinger, 
35,  46;  U.  S.  V.  Singer,  56  (foot- 
note), 60  (footnote);  U.S.  v. 
Smull,  97  (footnote);  U.S.  v. 
Standard  Brewing  Co.,  102;  U.  S. 
V.  200  Barrels  of  Whiskey,  102; 
U.  S.  V.  U.  S.  Verde  Copper  Co., 
102 

Value,  standard  of     ....  16,  27 
Van     Brocklin    v.    Tennessee, 

53  (footnote) 

Van  Derlip,  Mr 67-68 

Van   Devanter,   Justice  Willis, 

57  (footnote) 

Veazie  Bank  v.  Fenno,  56  (footnote), 

60  (footnote) 
Von  Baumbach  v.  Sargent  Land 

Co 67,  69  (footnote) 

Wages 41-43 

Wagner,  Adolf 21 

Waite,  Chief  Justice      .    .   101-102 

Waitev.  Macy 102,112 

War  facilities,  amortization  of, 

153-7 

War-Time  Prohibition  Act  .  .  102 
Waring  v.  Savannah,  137  (footnote) 
Warren,  Edward  H.,  70  (footnote) 

Wash  sales 86 

Webster,  George  R.,  201  (footnote) 
Weissenborn,  Hermann     ...     13 


INDEX 


271 


Weston  V.  Charleston,  53  (footnote)      Wickersham,  George  W.,  .    .  30-34 


Whisky  Rebellion  in  Pennsyl- 
vania     254 

White,  Chief  Justice,  57  (footnote), 
58-60,  64,  67-68,  85,  88 


Wisconsin    authorities    on    in- 
come        14-15 

Yachts,  foreign-built,  56,  58,  60,  87 


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